In this chapter’s opening story, 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.

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 have increased. Likewise, GDP can fall either because the economy is producing less or because prices have fallen.

In order to accurately measure the economy’s growth, we need a measure of real aggregate output: the total quantity of final goods and services the economy actually produces. 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 of goods and services over time. Let’s look first at how real GDP is calculated, 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 7-1.

The first thing we can say about these data is that the nominal value of sales increased from year 1 to year 2. In the first year, the total value of sales was (2000 billion × $0.25) +(1000 billion × $0.50) = $1000 billion; in the second it was (2200 billion × $0.30) + (1200 billion × $0.70) = $1500 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 from year 1 to year 2 simply reflects higher prices, not higher production of output.

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 (2200 billion × $0.25) (1200 billion × $0.50) = $1150 billion. And output in year 1 at year 1 prices was $1000 billion. So in this example, GDP measured in year 1 prices rose 15%—from $1000 billion to $1150 billion.

Now we can define real GDP: it is the total value of 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. A real GDP number always comes with information about what the base year is. Statistics Canada revises the base year every 10 years, and the current base year is 2002.

Sometimes, GDP is calculated using the prices of the same year in which the output is produced. Economists call this measure nominal GDP, GDP at current prices. Nominal GDP has not been adjusted for changes in prices and thus can be distorted by price changes (i.e., inflation or deflation). If we had used nominal GDP to measure the true 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 the same 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 7-2 shows a real-life version of our apples and oranges example. The second column shows the nominal GDP in 1992, 2002, and 2011. The third column shows the real GDP for each year in 2002 dollars. For 2002, the two numbers are the same—as is always the case—in the base year nominal GDP equals real GDP. But the real GDP in 1992 expressed in 2002 dollars was higher than the nominal GDP in 1992, reflecting the fact that prices were in general higher in 2002 than in 1992. However, the real GDP in 2011, expressed in 2002 dollars, was less than the nominal GDP in 2011 because prices in 2002 were lower than in 2011.

You might have noticed that there is an alternative way to calculate real GDP using the data in Table 7-1. 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 (2000 billion×$0.30) + (1000 billion × $0.70) = $1300 billion; real GDP in year 2 at year 2 prices is $1500 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 ($1500 billion − $1300 billion)/$1300 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%. Neither answer, 15.4% versus 15%, is more “correct” than the other.

In reality, the government economists who put together Canada’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, Canada’s statistics on real GDP are always expressed in chained dollars.

Now that we know what real GDP is, we can examine the growth rate of Canada’s real GDP. It is useful to do so, because real GDP is one of the most closely followed pieces of data that Statistics Canada releases. This is because the real GDP tells whether our economy is slowing down or expanding. Figure 7-4 depicts Canada’s real GDP growth rate from 1962 to 2011. As you see, its growth rate fluctuated during that period, showing that business cycles indeed are a common feature for any economy, including our own. As you know from Chapter 6, Canada experienced three recessions during this period: one in the early 1980s, one in the 1990s, and one in 2008–2009. The recession in the 1980s was partly the result of the two oil price shocks in the 1970s, during which the price of oil skyrocketed. The recession in the early 1990s was the result of a U.S. recession and of a deflationary (contractionary) monetary policy undertaken by the Bank of Canada. The most recent recession was triggered by the financial crises that originated in the United States. During these recessions, the country’s real GDP growth turned negative as firms, seeing the demand for their products soften, lowered their production. The diagram clearly shows another important fact—over the last several decades the growth rate of real GDP has been trending downward. Chapter 9 will discuss long-run growth in greater detail.

GDP, nominal or real, is a measure of a country’s aggregate output. Other things being 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.

Real GDP per capita can be a useful measure in some circumstances, such as in a comparison of labour productivity between 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.

One way to think about this issue is to say that an increase in real GDP means an expansion in the economy’s production possibility frontier. Because the economy has increased its productive capacity, there are more things that society can achieve. But whether society actually makes good use of that increased potential to improve living standards is another matter. To put it in a slightly different way, your income may be higher this year than last year, but whether you use that higher income to actually improve your quality of life is your choice.

So let’s say it again: real GDP per capita is a measure of an economy’s average aggregate output per person—and so of what it can do. It is not a sufficient goal in itself because it doesn’t address how a country uses that output to affect living standards. A country with a high GDP can afford to be healthy, to be well educated, and in general to have a good quality of life. But there is not a one-to-one match between GDP and the quality of life.