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We have used real GDP to measure growth and the growth rate in the beginning of this chapter, and then nominal GDP as recorded in the National Accounts. Now we need to look carefully at both concepts and the relationship between them, which is the GDP deflator, a measure of the general price level. Nominal GDP measures output and incomes based on current market prices for goods and services and factors of production. As a result, changes in nominal GDP from one period to the next might be the result of changes in prices of final outputs and factor inputs, or the result of changes in the quantities of final outputs and factor inputs, or some combination of the two. Since it is physical quantities of goods and services that yield satisfaction or utility, it can be misleading to judge the economy's performance by looking at nominal GDP. For that purpose we need real GDP, as we discussed earlier in this chapter. Real GDP, or GDP in constant prices, measures the value of goods and services produced in any given year using the prices of a base year. In this way, real GDP adjusts changes in GDP for changes in prices by measuring GDP in different years in constant prices.
Table 4.4 Nominal and real GDP
2007 | 2017 | % change | ||
Quantity | blue jeans | 4,000 | 5,000 | 25 |
solar panels | 2,000 | 4,000 | 100 | |
Price in current $ | blue jeans | 25 | 50 | 100 |
solar panels | 100 | 60 | –40 | |
Current value | blue jeans | 100,000 | 250,000 | 150 |
solar panels | 200,000 | 240,000 | 20 | |
Nominal GDP | 300,000 | 490,000 | 63 | |
Value in 2007 $ | blue jeans | 100,000 | 125,000 | 25 |
solar panels | 200,000 | 400,000 | 100 | |
Real GDP | 300,000 | 525,000 | 75 | |
GDP deflator | 100 | 93.3 | –6.7 |
To illustrate this important point, Table 4.4 shows a simple economy that produces both consumer goods, blue jeans, and capital goods, solar panels. In this economy nominal GDP rises from $300,000 to $490,000 between 2007 and 2017, a 63 percent increase measured in current prices as a result of changes in both quantities and prices. If we take 2007 as the base year, we can measure real GDP in 2017 by valuing output quantities in 2017 using 2007 prices. This gives real GDP in 2017 of $525,000 in prices of the base year. In the example in the table, quantities of both products rise over the period but the price of blue jeans rises while the price of solar panels falls. As a result the rise of about 75 percent in real GDP gives a true picture of the extra quantity of goods available in the economy in 2017 compared with 2007. It eliminates the change in nominal GDP that was the result of the fall in the average price level by 6.7 percent between 2007 and 2017 as a result of the fall in the price of solar panels.
The GDP deflator
The Canadian economy is obviously more complex than this economy. We have seen that GDP includes expenditures by households, governments, businesses, and residents of other countries who supply us with imports and buy our exports. To convert nominal GDP to real GDP we need to use an index that includes what is happening to the prices of all these different goods and services. This index is called the GDP deflator.
GDP deflator: index of current final output prices relative to base year prices.
If we have data for both nominal and real GDP, we can calculate the GDP deflator as the ratio of nominal GDP to real GDP expressed as an index with a value of 100 in the base year.
(4.8) |
The GDP deflator differs from the consumer price index (CPI) illustrated in Example Box 4.1 and used to measure inflation in consumer prices and the cost of living. First, the CPI is based on a "representative basket" of goods and services that consumers buy, while the GDP deflator is comprehensive and covers all the goods and services included in national accounts. Second, the CPI changes over time with changes in the prices of the basket of consumer goods and services. The GDP deflator, by contrast, is built on the base year prices. It changes over time as the current prices change relative to base year prices. In other words the GDP deflator is used to "deflate" the dollar value of current 2017 output to what value it would be in 2007 prices, while the CPI measures the increase in the cost of the "basket" of consumer goods and services.
But why does the GDP deflator change over time? From our earlier discussion of the national income accounting framework, we can see that costs of production and net indirect taxes are included in the general level of market prices measured by the GDP deflator. Nominal GDP measured by the income approach is reported in Table 4.3. It is the sum of incomes paid to factor inputs to production, plus depreciation allowances and net indirect taxes. These components of nominal GDP are the costs of production, gross profits, and taxes that are built into the market prices of the goods and services.
The general price level in the economy is the dollar amount paid for a 'unit of output' and, subtracting indirect taxes, the revenue received by producers for the sale of 'unit of output'. Revenue per unit of output must cover costs per unit of output, including expected profit, for producers to be willing to continue operations. Changes in costs must be covered eventually by changes in prices. Or if market conditions raise prices—think about crude oil production or lumber production—producers will increase output, as long as higher prices cover higher costs.
Summarizing from the national accounts gives three components of cost per unit of output:
- employee compensation per unit of output, W/Y;
- gross business income per unit of output, (GCS+GMI)/Y; and
- net indirect tax per unit of output, .
Changes in the sum of these three components of the price level must change both price and nominal GDP, whether we measure nominal GDP by the income or the expenditure approach. The GDP deflator is an index of this price level in any particular year relative to a chosen base year. However, the accounting framework does not explain the causes of change in the price level. That requires explanations of changes in unit labour costs, of producer output and pricing decisions and information on the net indirect tax rate. Those explanations are parts of an economic model of the supply side of the economy.
To show the empirical importance of the distinction between real and nominal GDP, Table 4.5 gives Canadian data over the period 2004 to 2016. Nominal GDP rose from $1,331 billion in 2004 to $2,027 billion in 2016. Without knowing what happened to prices of goods and services in general, we cannot judge what happened to the quantity of output over that period. To answer this question we use the GDP deflator to convert nominal GDP to real GDP in the prices of the base year 2007 as follows:
(4.9) |
Table 4.5 Canadian nominal and real GDP 2004–2016
2004 | 2008 | 2012 | 2016 | |
Nominal GDP (billions $) | 1,331 | 1,653 | 1,823 | 2,027 |
GDP deflator (2007=100) | 91.4 | 104.0 | 109.2 | 112.9 |
Real GDP (billions 2007 $) | 1,456 | 1,589 | 1,669 | 1,796 |
Source: Statistics Canada, CANSIM Tables 380-0064 and 380-0066
For example, in 2016, nominal GDP was $2,027 billion and the GDP deflator () was 112.9. Real GDP measured in constant 2007 dollars was then:
When converted to constant dollars, the change in real GDP is much smaller than the change in nominal GDP. Over the 2004–2016 period shown in the table, real GDP increased by 23.4 percent compared to a 52.3 percent increase in nominal GDP. On average, prices in 2016 were 23.5 percent higher than in 2004. Clearly, it is important to distinguish between nominal and real GDP.