What if you read that GDP has increased over the last year? Does that mean the economy has produced more goods and services during the year? This is not necessarily true. Recall that GDP is the value of final goods and services. How is this value measured? GDP is measured in current year dollars, meaning the year in which the goods and services are produced. Current dollars are also known as nominal dollars and, thus, this measure of GDP is known as nominal GDP.
Because nominal GDP uses current dollars to measure value, it gives rise to a limitation. With inflation, prices increase across the economy. This means the prices used to measure GDP go up. An increase in GDP, therefore, can stem from an increase in aggregate output and/or an increase in prices. Therefore, if a news report cites an increase in GDP, it may simply be due to an increase in inflation. Consider a situation where the economy simultaneously experiences both recession and high inflation, as it did during the "stagflation" of the late 1970s. If the rate of inflation exceeds the rate of contraction of the economy, GDP could increase even though aggregate output declines!
REALITY CHECK: Heres a simple numerical example. Suppose last year a firm made 5 units of its product, which it sold for $10,000 each. Its contribution to GDP was $50,000. This year its contribution is $60,000. Does that necessarily mean it produced more units of the product? It could be that it made 6 and sold them at $10,000 each, but it could have still produced 5 and sold them at $12,000 each. Or it could even have produced only 4 and sold them at $15,000 each!
We will next discuss how the Bureau of Economic Analysis (BEA) adjusts nominal GDP for price changes. In that discussion, we will use the concept of a weight which is a way to show that all changes are not equally important. A good example of a weight is the calculation of your grade point average (or index), in which the grade you receive for a course is weighted by the number of credits for the course.
REALITY CHECK: The idea is really simple. What would affect you more, a 10% increase in your tuition bill or a 10% increase in the price of ballpoint pens? Excepting those people who might be on scholarship, most students would be affected more by the price change in tuition because it represents a bigger part of their spending. Thats why price changes need to be weighted.
To more fully understand the difference between nominal and real GDP, try the following Active Graph exercise: