Lecture slides for an undergraduate course on Basic Macroeconomics that I taught in the Fall of 2007. This lecture goes over the difference between real and nominal GDP.

1. The real-nominal principle
Price Indexing and the GDP Deflator

2. “Apples and Oranges”
• Price is often used as a proxy for market value.
• The problem with this is that prices change over time.
• This means that a dollar in 1997 may not have the same
value as a dollar in 2007.
• Thus, we have to be clear about what how we look at dollar
and product values:
• In nominal terms, we make refer to the price as
expressed in current dollars (i.e. the stated price).
• In real terms, we take into account the purchasing power
of those dollars.
On the comparability of GDP data (and monetary data in general).

3. Price Indexing
• The simple way to do this:
• Pick a base year.
• Weigh the goods from Year A and Year B by the prices
from the base year.
Making product values across years comparable.
∑ P x Q
A A
∑ P x Q
B B
Nominal GDP
in Year A
=
Nominal GDP
in Year B
=
∑ P x Q
B A
∑ P x Q
B B
Year A GDP in
Year B Dollars
=
Year B GDP in
Year B Dollars
=

4. Price Indexing
• The simple way to do this:
• Pick a base year.
• Weigh the goods from Year A and Year B by the prices
from the base year.
Making product values across years comparable.
∑ P x Q
A A
∑ P x Q
B B
Nominal GDP
in Year A
=
Nominal GDP
in Year B
=
∑ P x Q
B A
∑ P x Q
B B
Year A GDP in
Year B Dollars
=
Year B GDP in
Year B Dollars
=
REAL
(Comparable!)
NOMINAL
(Not Comparable!)

5. A Numerical ExampleComputing Nominal and Real GDP
2005 2006
Price Qty Price Qty
Food $5 30 $3 35
Clothing $16 10 $20 8
Housing $500 1 $550 2

6. Price Indexing II
• The obvious problem with fixed-weight indices is that “real”
percent changes (i.e. growth rates) from one year to
another are sensitive to the choice of the base year.
• One way to overcome this is to use chain weights to
compute growth rates.
• An example of this is the procedure used by the Bureau of
Economic Analysis (BEA), which simply takes the geometric
average:
Fixed vs. Chain-weight procedures
Chain-Weighted
Growth Rate
=
Growth Rate if
Prior Year is Base Year√ Growth Rate if
Current Year is Base
x

7. Again...An illustration of chain-weighting.
2005 2006
Price Qty Price Qty
Food $5 30 $3 35
Clothing $16 10 $20 8
Housing $500 1 $550 2

8. The GDP DeflatorAnother useful macroeconomic statistic
GDP Deflator =
Nominal GDP
Real GDP
*It is a “deflator” because it tells us by how much we have to divide
Nominal GDP to get the equivalent Real GDP for a given year.

9. Comparing GDPGDP as a measure of an economy’s size.
COUNTRY GDP ($ BN)
USA 13,770.31
Japan 4,302.09
Germany 3,080.55
China 3,051.24
UK 2,660.66
France 2,401.44
Italy 1,993.72
Spain 1,359.91
Canada 1,266.40
Brazil 1,177.71
Source: IMF World Economic Outlook
Database.
COMPANY REVENUES ($ BN)
Wal-Mart 351.14
Exxon-Mobil 347.25
R. D. Shell 318.85
BP 274.31
GM 207.35
Toyota 204.75
Chevron 200.57
DaimlerChrysler 190.19
ConocoPhillips 172.45
Total 168.36
Source: Fortune 500 World’s Largest
Companies.

10. GDP and its Limitations
• It does not account for all productive activity in the
economy.
• It ignores other equally valid components of social welfare.
• It does not necessarily represent “desirable” economic
activity.
• It does not capture all the costs of economic activity.
• It offers no indication of how the “wealth” is distributed.
Remember: GDP is only an imperfect measure at best.