Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Why real GDP is the real deal

Real GDP is what really interests economists – because it tells them how much stuff the economy is producing in a year. Similarly, if real GDP goes up by 2 per cent, they know that the quantity of goods and services produced in an economy has gone up by 2 per cent. Nominal GDP figures are less helpful: for example, a number of reasons may explain why nominal GDP rises by 5 per cent in a year:

The price level was unchanged and the actual quantity of goods being produced increased by 5 per cent.

The price level increased by 5 per cent and the actual quantity of goods being produced remained unchanged.

The price level increased by 10 per cent and the actual quantity of goods being produced fell by 5 per cent.

Despite these very different scenarios, in all three cases nominal GDP has risen by 5 per cent. Real GDP, however, has increased by 5 per cent in the first case, remained unchanged in the second case and fallen by 5 per cent in the third case. Economists think that people should care about the amount of goods being produced rather than the nominal value of those goods, so the changes in real GDP are what really count!

Nominal GDP equals real GDP in the base year

As the preceding section explains, real GDP is calculated using the price level in the base year. Figure 4-1 shows the real and nominal GDP for the UK. Real GDP is calculated using 2011 as the base year, which means that real GDP in all other years is calculated using the price of things in 2011. This approach allows economists to compare output in a meaningful way across time. For example, the UK produced about twice as much output in the mid-2000s as it did in the late 1970s/early 1980s. Equally, you can see that total output fell in the late 2000s as a result of the global financial crisis.

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Figure 4-1: UK real and nominal GDP.

Another thing to notice is that real GDP and nominal GDP are exactly equal in 2011. This isn’t by accident: 2011 is the base year and real GDP that year has been calculated on the basis of prices in 2011. Nominal GDP is always

calculated using the prices that were prevalent at the time. Thus real GDP and nominal GDP always coincide at the base year.

We chose the base year of 2011 arbitrarily and could equally have chosen another year. A different choice wouldn’t affect the graph of nominal GDP but would change the graph of real GDP to ensure that it was equal to nominal GDP during the base year. For example, if the base year was 1980, the real GDP ‘number’ for all the years would be much lower than the numbers in Figure 4-1, not because a different base year affects total output or living standards, but because the real GDP figures would be based on what you could buy with £1 in 1980.