1.4 Module 12: Interpreting Real Gross Domestic Product

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What GDP Tells Us

We now know what gross domestic product (GDP) is and how it’s calculated. But what does the measurement of GDP tell us?

The most important use of GDP is as a measure of the size of the economy, providing us a scale against which to compare the economic performance of other years or other countries. For example, in 2013, U.S. GDP was $16,803 billion, China’s GDP was $9,272 billion, and the combined GDP of the 28 countries that make up the European Union was $17,267 billion. This comparison tells us that China, although it has the world’s second-largest national economy, carries considerably less economic weight than does the United States. When taken in aggregate, Europe’s economy is larger than the U.S. economy.

Still, one must be careful when using GDP numbers, especially when making comparisons over time. That’s because part of the increase in the value of GDP over time represents increases in the prices of goods and services rather than an increase in output. For example, U.S. GDP was $7,085 billion in 1994 and had approximately doubled to $14,990 billion by 2011. But U.S. production didn’t actually double over that period. To measure actual changes in aggregate output, we need a modified version of GDP that is adjusted for price changes, known as real GDP. We’ll see how real GDP is calculated next.

Real GDP: A Measure of Aggregate Output

In the section-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 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. 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.

Calculating Real GDP

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 12-1.

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 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 (2,200 billion × $0.25) + (1,200 billion × $0.50) = $1,150 billion. And output in year 1 at year 1 prices was $1,000 billion. So in this example, GDP measured in year 1 prices rose 15%—from $1,000 billion to $1,150 billion.

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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. 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, GDP at current prices. 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 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 12-2 shows a real-life version of our apples and oranges example. The second column shows nominal GDP in 2001, 2005, and 2012. 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 2001 expressed in 2005 dollars was higher than nominal GDP in 2001, reflecting the fact that prices were in general higher in 2005 than in 2001. Real GDP in 2012 expressed in 2005 dollars, however, was less than nominal GDP in 2012 because prices in 2005 were lower than in 2012.

You might have noticed that there is an alternative way to calculate real GDP using the data in Table 12-1. 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%. Neither answer, 15.4% versus 15%, 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.

!world_eia!MIRACLE IN VENEZUELA?

The South American nation of Venezuela has a distinction that may surprise you: in recent years, it has had one of the world’s fastest-growing nominal GDPs. Between 2000 and 2011, Venezuelan nominal GDP grew by an average of 29% each year—much faster than nominal GDP in the United States or even in booming economies like China.

So is Venezuela experiencing an economic miracle? No, it’s just suffering from unusually high inflation. Figure 12-1 shows Venezuela’s nominal and real GDP from 2000 to 2011, with real GDP measured in 1997 prices. Real GDP did grow over the period, but at an annual rate of only 3%. That’s about twice the U.S. growth rate over the same period, but it is far short of China’s 10% growth.

Source: Banco Central de Venezuela.

What Real GDP Doesn’t Measure

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—and so of what it can do. A country with a high real 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 real GDP and the quality of life. Real GDP doesn’t address how a country uses that output to affect living standards, it doesn’t include some sources of well-being, and it does include some things that are detriments to well-being.

!world_eia!GDP AND THE MEANING OF LIFE

Real GDP doesn’t include many of the things that contribute to quality of life and happiness.

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“I’ve been rich and I’ve been poor,” the actress Mae West famously declared. “Believe me, rich is better.” But is the same true for countries?

This figure shows two pieces of information for a number of countries: how rich they are, as measured by GDP per capita, and how people assess their well-being. Well-being was measured by a Gallup world survey that asked people to rate their lives at the current time and their expectations for the next five years. The graph shows the percentage of people who rated their well-being as “thriving.” The figure seems to tell us three things:

1. Rich is better. Richer countries on average have higher well-being than poor countries.
2. Money matters less as you grow richer. The gain in life satisfaction as you go from GDP per capita of $20,000 to $30,000 is greater than the gain as you go from $40,000 to $50,000.
3. Money isn’t everything. Israelis, though rich by world standards, are poorer than Americans—but they seem more satisfied with their lives. Japan is richer than most other nations, but by and large, quite miserable.

These results are consistent with the observation that high GDP per capita makes it easier to achieve a good life but that countries aren’t equally successful in taking advantage of that possibility.

Source: Gallup; World Bank.

Module 12 Review

Check Your Understanding

Use the information in the accompanying table to answer the following questions.