22.b. Price Indexes and GDP Deflator

Nominal variables are variables that are measured in terms of current market values. Using market values to measure economic activity is an advantage that allows different types of goods and services to be summed up. But a problem arises if you want to compare the values of an economic variable at two different points in time. If GDP changes over time, you can’t tell whether changes are reflected by the change in quantity or prices of goods and services.

Economic variable is measured by prices in a base year, called real variable. Real economic variables measure quantity of economic activity. Real GDP measures the physical volume of an economy’s final production using base year. Nominal GDP is the dollar value of an economy’s final output measured at current market prices. Real GDP and nominal GDP are equal in the base year.

A price index is a measure of the average level of prices for some specified set of goods and services, relative to the prices in a specified year. GDP deflator is a price index that measures the overall level of prices of goods and services included in GDP. It is often given in the formula:

Real GDP = nominal GDP/GDP deflator (22.1)

The GDP deflator is the amount that nominal GDP is divided by to obtain real GDP. You can rewrite the equation as:

GDP deflator = nominal GDP/ real GDP. (22.2)

In the first year, nominal and real GDP are equal. That means that the GDP deflator equals to 1. Let’s say that in year 2, nominal GDP is $35,000 and real DGP is $30,000. That means that the GDP deflator for year 2 is $35,000/30,000 = 1.1667. The overall level of prices, measured by the GDP deflator, is 1.667% higher in year 2 than in year 1.

Quiz Questions:

  1. What is real GDP?
  2. What is nominal GDP?
  3. What does GDP deflator measure, and what is the formula?
  4. Consider an economy what produces 2 types of veggies: carrots and beans. In the base year, the production and price data were as follows:

VeggiesQuantityPrice

Carrots250 bags$2.00 per bag

Beans325 bags$3.00 per bag

In the current year the production and price are as follows:

VeggiesQuantityPrice

Carrots350 bags$3.00 per bag

Beans700 bags$2.00 per bag

Find the real GDP in the current year and base year.

  1. Find the nominal GDP in current year.
  2. What is the GDP deflator in the current year?

Answers:

  1. Real GDP is the measure of physical volume of an economy’s final production using base year
  2. Nominal GDP is the dollar value of an economy’s final output measured at current market prices
  3. The GDP deflator measures the overall level of prices of goods and services included in GDP and its equation is

Real GDP = nominal GDP/GDP deflator

  1. Real GDP in base year = 1475 real GDP in current year = 2800
  2. Nominal GDP current = 2475
  3. GDP deflator in current year is 2800/2475 = 1.131, which is 1.31% higher in current year than base year.