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 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 of goods and services over time. Let’s look first at how real GDP is calculated, then at what it means.