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Understanding how economists adjust for price changes to see if an economy is actually growing.
If you earned 110 this year, you would feel 10% richer—but what if the price of your favorite pizza also went up by 20%? Are you actually better off, or is it just an illusion?
Let's look at a tiny country that only makes skateboards.
1. In Year 1, they produce 50 skateboards.
2. Each skateboard sells for 50 \times \$100 = \$5,000$.
Quick Check
If a country produces the exact same number of items as last year, but every price doubles, what happens to the Nominal GDP?
Answer
The Nominal GDP would double, even though the actual production stayed the same.
The problem with Nominal GDP is inflation—the general increase in prices over time. If the price of bread goes from 4, the Nominal GDP contributed by that bread doubles, even if we didn't bake a single extra loaf. This creates a 'money illusion' where the economy looks like it is booming on paper, but people aren't actually getting more goods or services. To see the truth, economists use Real GDP, which strips away the effects of price changes by using prices from a fixed point in time, known as a Base Year.
Compare two years in an apple-only economy:
1. Year 1 (Base Year): 100 apples sold at Nominal\ GDP = \.
2. Year 2: 100 apples sold at Nominal\ GDP = \.
3. To find Real GDP for Year 2, we use Year 1 prices: $100\ apples \times \$1 = \.
4. Result: Nominal GDP grew by 100%, but Real GDP growth was 0%!
Quick Check
Why is Real GDP a better measure of economic health than Nominal GDP?
Answer
Because it measures the actual volume of production (the 'stuff' we have) rather than just the dollar value, which can be distorted by rising prices.
Let's calculate growth between two years:
1. Base Year (2020): Price = GDP = \.
2. Current Year (2024): Price = 120 \times \$15 = \$1,800120 \times \$10 = \$1,200800, the actual production (Real) only grew by $200 worth of shirts.
Which of the following is used to calculate Real GDP?
If a country's Nominal GDP increases by 5% but inflation is also 5%, what happened to Real GDP?
Nominal GDP will always be higher than Real GDP if prices have risen since the base year.
Review Tomorrow
In 24 hours, try to explain to someone why a country's GDP might look like it's growing even if people are becoming poorer.
Practice Activity
Find a news article about 'GDP Growth.' Check if they are talking about 'Real GDP' or 'Nominal GDP.' (Hint: Most serious economic reports always use Real GDP!)