Module Interpreting Real Gross Domestic Product 11 KRUGMAN'S MACROECONOMICS for AP* Margaret Ray and David Anderson

What you will learn in this Module: What is the difference between real GDP and nominal GDP? How to chain-link GDP? Why is real GDP the appropriate measure of real economic activity?

Real GDP: A Measure of Aggergate Output Nominal GDP: the raw number of a year’s production and prices Real GDP: nominal GDP chain-linked with a previous year’s inflation value Chain linking: using a currency value from a previous year to calculate Real GDP. This helps us compare numbers despite inflation. GDP is really a P*Q measure. You take the quantity of output (Q) and multiply by the price of the output (P). If prices rise, and Q stays the same, GDP will increase. This is misleading because the true size of the economy hasn’t increased, it has just gotten more expensive. To adjust for changing prices, we create Real GDP, which calculates the value of current production, but using prices from a fixed point in time. This fixed point in time is called the base year. Valuing 2009 production at 2008 prices creates real GDP in 2009 and allows us to compare it back to 2008 (the base year). This is also known as constant-dollar GDP.   Note: The instructor can now show the real GDP numbers for the same years from the table of nominal GDP numbers. Explain which year is the base year. Then show how the real size of the economy has changed from the 1980s to recent years.

Calculating Real GDP Year Tons of Corn Price per Ton Tons of Soybeans Nominal GDP Real GDP Base Year = 2007 2007 100 $100 80 $50 (100*$100) + (80*$50) = $14,000 $14,000 2008 110 $110 (110*$110) + (80*$50) = $20,100 (110*$100) + (80* $50) = $15,000 Suppose an economy consists of only two commodities. The table above shows prices and output levels for two recent years. Note: The instructor might want to select two goods/services that are relevant to the local community or state. Nominal GDP in each year multiplies current prices by current levels of output.   In this simple economy, nominal GDP has risen by $6100. In % terms: (20,100 – 14,000)/14,000 = .436 or 43.6% WOW! The politicians will really be proud of themselves!!! But was this increase due to a fundamental increase in output, or was it due to higher prices? Let’s hold prices constant at 2007 levels and compute the value of real GDP. By choosing to use 2007 prices, we have made 2007 our base year. Notice that nominal GDP = real GDP in the base year of 2007. Now we compute real GDP in 2008 by using output in 2008, but at prices from 2007. Real GDP 2008 = $15,000, so in real terms the value of the economic output has only risen by $1000 In % terms: (15,000 – 14,000)/14,000 = .071 or 7.1% Note: The instructor could add a third year where real GDP actually falls and introduce the class to what it means when the data indicates a recession.

Practice Note: Stress to the students that GDP, and real GDP, are just statistical measures. They are positive, not normative. They should not be used to measure a nation’s self-esteem, or sense of overall happiness.   Many of the things that make people happy do not contribute to this statistic. Taking time off from work to coach your child’s soccer team. Volunteerism detracts from GDP. Many forms of leisure do not contribute to GDP. Read a book, take a walk, play catch with your child and you are hurting the economy. Work around the house. If you rake your own leaves, rather than hire a company to do it, you detract from GDP. If you decided to drop out of the labor force to help raise kids, you detract from GDP. Some things that contribute to GDP don’t make us happier. Spending money to put bars in your windows because your neighborhood is unsafe will add to GDP. Likewise, imagine two economies. One is based upon the buying/producing of assault rifles and one is based upon the buying/producing of ice cream. Both will add to GDP, but which is “better”? Cleaning up after a natural disaster (Katrina, or a snow storm) will add to GDP. Spending money to fight preventable diseases (emphysema) will add to GDP.

GDP Deflator = (Nominal GDP/Real GDP) x 100 Shows change in price level between a year and a base year [chain linked year] GDP Deflator = (Nominal GDP/Real GDP) x 100 GDP is really a P*Q measure. You take the quantity of output (Q) and multiply by the price of the output (P). If prices rise, and Q stays the same, GDP will increase. This is misleading because the true size of the economy hasn’t increased, it has just gotten more expensive. To adjust for changing prices, we create Real GDP, which calculates the value of current production, but using prices from a fixed point in time. This fixed point in time is called the base year. Valuing 2009 production at 2008 prices creates real GDP in 2009 and allows us to compare it back to 2008 (the base year). This is also known as constant-dollar GDP.   Note: The instructor can now show the real GDP numbers for the same years from the table of nominal GDP numbers. Explain which year is the base year. Then show how the real size of the economy has changed from the 1980s to recent years.

Save time – use logic! 1) If the real GDP is $100, and the deflator is 110, what’s the nominal GDP? 2) If the nominal GDP is $200, and the deflator is 95, what’s the real GDP? GDP is really a P*Q measure. You take the quantity of output (Q) and multiply by the price of the output (P). If prices rise, and Q stays the same, GDP will increase. This is misleading because the true size of the economy hasn’t increased, it has just gotten more expensive. To adjust for changing prices, we create Real GDP, which calculates the value of current production, but using prices from a fixed point in time. This fixed point in time is called the base year. Valuing 2009 production at 2008 prices creates real GDP in 2009 and allows us to compare it back to 2008 (the base year). This is also known as constant-dollar GDP.   Note: The instructor can now show the real GDP numbers for the same years from the table of nominal GDP numbers. Explain which year is the base year. Then show how the real size of the economy has changed from the 1980s to recent years.

What Real GDP Doesn’t Measure Real GDP v. GDP per capita Living Standards Limitations of Real GDP per capita Positive vs. Normative statements Discussion: what desirable things hurt GDP, and what undesirable things help GDP? Note: Stress to the students that GDP, and real GDP, are just statistical measures. They are positive, not normative. They should not be used to measure a nation’s self-esteem, or sense of overall happiness.   Many of the things that make people happy do not contribute to this statistic. Taking time off from work to coach your child’s soccer team. Volunteerism detracts from GDP. Many forms of leisure do not contribute to GDP. Read a book, take a walk, play catch with your child and you are hurting the economy. Work around the house. If you rake your own leaves, rather than hire a company to do it, you detract from GDP. If you decided to drop out of the labor force to help raise kids, you detract from GDP. Some things that contribute to GDP don’t make us happier. Spending money to put bars in your windows because your neighborhood is unsafe will add to GDP. Likewise, imagine two economies. One is based upon the buying/producing of assault rifles and one is based upon the buying/producing of ice cream. Both will add to GDP, but which is “better”? Cleaning up after a natural disaster (Katrina, or a snow storm) will add to GDP. Spending money to fight preventable diseases (emphysema) will add to GDP.