At the beginning of this section we described how China passed Japan as the world’s second-largest economy in 2010. At the time, Japan’s economy was weakening: during the second quarter of 2010, output declined by an annual rate of 6.3%. Oddly, however, GDP was up. In fact, Japan’s GDP measured in yen, its national currency, rose by an annual rate of 4.8% during the quarter. How was that possible? The answer is that Japan was experiencing inflation at the time. As a result, the yen value of Japan’s GDP rose although output actually fell.

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The moral of this story is that the commonly cited GDP number is an interesting and useful statistic, one that provides a good way to compare the size of different economies, but it’s not a good measure of the economy’s growth over time. GDP can grow because the economy grows, but it can also grow simply because of inflation. Even if an economy’s output doesn’t change, GDP will go up if the prices of the goods and services the economy produces increase. Likewise, GDP can fall either because the economy is producing less or because prices have fallen.

To measure the economy’s growth with accuracy, we need a measure of aggregate output: the total quantity of final goods and services the economy produces. As we noted above, the measure that is used for this purpose is known as real GDP. By tracking real GDP over time, we avoid the problem of changes in prices distorting the value of changes in production over time. Let’s look first at how real GDP is calculated and then at what it means.

To understand how real GDP is calculated, imagine an economy in which only two goods, apples and oranges, are produced and in which both goods are sold only to final consumers. The outputs and prices of the two fruits for two consecutive years are shown in Table 11.1.

The first thing we can say about these data is that the value of sales increased from year 1 to year 2. In the first year, the total value of sales was (2,000 billion × $0.25) + (1,000 billion × $0.50) = $1,000 billion; in the second, it was (2,200 billion × $0.30) + (1,200 billion × $0.70) = $1,500 billion, which is 50% larger. But it is also clear from the table that this increase in the dollar value of GDP overstates the real growth in the economy. Although the quantities of both apples and oranges increased, the prices of both apples and oranges also rose. So part of the 50% increase in the dollar value of GDP simply reflects higher prices, not increased production.

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To estimate the true increase in aggregate output produced, we have to ask the following question: How much would GDP have gone up if prices had not changed? To answer this question, we need to find the value of output in year 2 expressed in year 1 prices. In year 1, the price of apples was $0.25 each and the price of oranges $0.50 each. So year 2 output at year 1 prices is (2,200 billion × $0.25) + (1,200 billion × $0.50) = $1,150 billion. Since output in year 1 at year 1 prices was $1,000 billion, GDP measured in year 1 prices rose 15%—from $1,000 billion to $1,150 billion.

Now we can define real GDP: it is the total value of all final goods and services produced in the economy during a year, calculated as if prices had stayed constant at the level of some given base year in order to remove the effects of price changes. A real GDP number always comes with information about what the base year is. A GDP number that has not been adjusted for changes in prices is calculated using the prices in the year in which the output is produced. Economists call this measure nominal GDP, or GDP at current prices. If we had used nominal GDP to measure the change in output from year 1 to year 2 in our apples and oranges example, we would have overstated the true growth in output: we would have claimed it to be 50%, when in fact it was only 15%. By comparing output in the two years using a common set of prices—the year 1 prices in this example—we are able to focus solely on changes in the quantity of output by eliminating the influence of changes in prices.

Table 11.2 shows a real-life version of our apples and oranges example. The second column shows nominal GDP in 2000, 2005, and 2013. The third column shows real GDP for each year in 2005 dollars (that is, using the value of the dollar in the year 2005). For 2005 the nominal GDP and the real GDP are the same. But real GDP in 2000 expressed in 2005 dollars was higher than nominal GDP in 2000, reflecting the fact that prices were in general higher in 2005 than in 2000. Real GDP in 2013 expressed in 2005 dollars, however, was less than nominal GDP in 2013 because prices in 2005 were lower than in 2013.

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You might have noticed that there is an alternative way to calculate real GDP using the data in Table 11.1. Why not measure it using the prices of year 2 rather than year 1 as the base-year prices? This procedure seems equally valid. According to that calculation, real GDP in year 1 at year 2 prices is (2,000 billion × $0.30) + (1,000 billion × $0.70) = $1,300 billion; real GDP in year 2 at year 2 prices is $1,500 billion, the same as nominal GDP in year 2. So using year 2 prices as the base year, the growth rate of real GDP is equal to ($1,500 billion − $1,300 billion)/$1,300 billion = 0.154, or 15.4%. This is slightly higher than the figure we got from the previous calculation, in which year 1 prices were the base-year prices. In that calculation, we found that real GDP increased by 15.0%. Neither answer, 15.4% versus 15.0%, is more “correct” than the other. In reality, the government economists who put together the U.S. national accounts have adopted a method to measure the change in real GDP known as chain-linking, which uses the average between the GDP growth rate calculated using an early base year and the GDP growth rate calculated using a late base year. As a result, U.S. statistics on real GDP are always expressed in chained dollars, which splits the difference between using early and late base years.

GDP is a measure of a country’s aggregate output. Other things equal, a country with a larger population will have higher GDP simply because there are more people working. So if we want to compare GDP across countries but want to eliminate the effect of differences in population size, we use the measure GDP per capita—GDP divided by the size of the population, equivalent to the average GDP per person. Correspondingly, real GDP per capita is the average real GDP per person.

Real GDP per capita can be a useful measure in some circumstances, such as in a comparison of labor productivity between two countries. However, despite the fact that it is a rough measure of the average real output per person, real GDP per capita has well-known limitations as a measure of a country’s living standards. Every once in a while, economists are accused of believing that growth in real GDP per capita is the only thing that matters—that is, thinking that increasing real GDP per capita is a goal in itself. In fact, economists rarely make that mistake; the idea that economists care only about real GDP per capita is a sort of urban legend. Let’s take a moment to be clear about why a country’s real GDP per capita is not a sufficient measure of human welfare in that country and why growth in real GDP per capita is not an appropriate policy goal in itself.

Real GDP does not include many of the things that contribute to happiness, such as leisure time, volunteerism, housework, and natural beauty. And real GDP increases with expenditures on some things that make people unhappy, including disease, divorce, crime, and natural disasters.

Real GDP per capita is a measure of an economy’s average aggregate output per person—an indication of the economy’s potential for certain achievements. Having studied the income approach to calculating GDP, you know that the value of output corresponds to the value of income. A country with a relatively high GDP per capita can afford relatively high expenditures on health, education, and other goods and services that contribute to a high quality of life. But how output is actually used is another matter. To put it differently, your income might be higher this year than last year, but whether you use that higher income to actually improve your quality of life is up to you. There is not a one-to-one match between real GDP and the quality of life. The real GDP per capita measure does not indicate how income is distributed. It doesn’t include some sources of well-being, and it does include some things that are detriments to well-being.

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