Nominal and Real GDP, GDP Price Index, GDP Deflator

A primary benefit of measuring the Gross Domestic Product (GDP) is that it can show economic growth over time, or its lack thereof. However, GDP as measured by current prices does not measure the growth of real GDP since prices depend on the money supply, money demand, technology, and aggregate supply versus demand, which varies independently of GDP from year to year. Nominal GDP is the GDP measured by actual prices, which are unadjusted for inflation. Real GDP measures output in constant dollars, so that the economic output of one year can be accurately compared to another year. Since prices change from year to year, GDP would change from year to year even if the real GDP did not change. Hence, there must be some adjustment in GDP to reflect the change in prices. Rising prices inflate GDP while falling prices deflate GDP. Therefore, to get real GDP, the operation must be reversed. Since prices usually rise, GDP is deflated by the amount of inflation to arrive at real GDP. Hence, it is often called the GDP deflator.

GDP Deflator = 100 × Nominal GDP / Real GDP

Real GDP is simply the nominal GDP deflated by the price index:

Real GDP = Nominal GDP / (GDP Deflator/100)

The GDP deflator is based on a GDP price index and is calculated much like the Consumer Price Index (CPI), based on data collected by the government. The GDP index covers many more goods and services than the CPI, including goods and services bought by businesses. The CPI only covers consumer goods and services, while the GDP index also covers capital goods, government purchases, and goods and services traded worldwide.

The Bureau of Economic Analysis (BEA), along with the Bureau of Labor Statistics (BLS), compiles the GDP accounts. BEA is an agency of the United States Department of Commerce that produces and distributes economic statistics about governments, businesses, households, and individuals. The most important of these statistics is the National Economic Accounts, which provides statistics on the production, distribution, and the use of economic output, the GDP being the most prominent. Most information for calculating the GDP accounts for consumption and investment comes from the United States Census Bureau. Information about government purchases and government wages and benefits, which is the single largest expenditure by the federal, state, and local governments, comes from the United States Office of Personnel Management. The Census Bureau also provides some of this information. Most information on net exports comes from the United States Customs Service. The Bureau of Labor Statistics provides most of the statistics on labor, which is the major input to GDP.

To determine the value of the GDP deflator, a GDP price index must be constructed that shows how much prices have changed from year to year for a representative sample of all products and services. The relative weights of various goods and services in the GDP price index are adjusted annually, unlike the CPI, which is a fixed weight price index for a market basket whose composition is only updated occasionally by the BLS.

A price index measures how much prices have changed in any given year compared to a base year:

Price Index
in a Given Year 		= Price of
Representative Market Basket
in Specific Year
Price of
Representative Market Basket
in Base Year		 × 100

The multiplication by 100 gives a nice round number, especially for reporting. However, to determine real GDP, the nominal GDP is divided by the price index divided by 100.

To simplify comparisons, the value of the price index is set at 100 for the base year. Before the base year, prices were generally lower, so those GDP values must be inflated to compare them to the base year. When prices are less in any given year than they were in the base year, then the price index will be less than 100, so that when real GDP is calculated by dividing the nominal GDP by the price index, it will exceed the nominal GDP. Real GDP = nominal GDP for the base year.

Another method of calculating real GDP is to enumerate the volume of output, then multiplying that volume by the prices of the base year. So if a gallon of gas cost $2 in Year 1, and the United States produced 10,000,000,000 gallons, then these values can be compared to a later year. For instance, if the United States produced 15,000,000,000 gallons of gasoline in Year 10, then the real increase in GDP with respect to gasoline could be calculated by simply multiplying the 15 billion by the 2000 price of $2 per gallon. The price index can then be calculated by dividing the nominal GDP by the real GDP. So if gasoline was $3 per gallon in Year 10, then the price index = 3 / 2 × 100 =150.

Of course, calculating real GDP by either method is more complicated. Statisticians must necessarily use assumptions about the proportion of each type of goods and services purchased in a given year.

Potential GDP and the Output Gap

One factor the Federal Reserve considers when deciding on monetary policy is whether the economy is producing its potential output. Potential output, estimated periodically by the Congressional Budget Office (CBO), is an estimate of what an economy could feasibly produce when fully employing its available economic resources. Hence, potential output is the same as potential GDP and is often described as the maximum sustainable output. Sustainable output means that the economy is functioning normally rather than maximally. So, for instance, employees are working regular hours, not overtime, and factories and other sources of production are producing quantities for which they were optimized. Hence, positive output gaps are possible, where the actual output exceeds potential output since the economy can utilize its resources at higher levels for short periods of time. However, negative output gaps are far more common. A negative output gap indicates that the economy is under utilizing its resources, which often means that the economy is operating at less than full employment. Negative output gaps occur during recessions and positive output gaps occur during economic booms; thus, the output gap mirrors the business cycle of booms and busts.

Output Gap = (Actual Output − Potential Output)
Potential Output		 × 100

If the output gap is negative, the Federal Reserve will adjust its monetary policy to stimulate the economy more; if positive, the Federal Reserve would increase the federal funds rate to cool the economy.