Watch this video and you’ll learn the difference between nominal GDP and real GDP with the help of a memorable story about a competition between twin brothers.
Measuring the Total Output of an Economy
Please go with me to a planet far, far away by the name of Econoland. On this planet are three countries: the nations of Macro, Micro, and Eden. In this lesson, you’ll learn the difference between real GDP and nominal GDP.
Why does this matter? Because, as you’ll find out, real GDP tells us how much a country really grew after adjusting for inflation.You’ll do this by following a lifelong drama of competition that develops between two identical twins, Arnold and Danny, who were born in the nation of Eden. These boys have great aspirations growing up. As toddlers, they accidentally solve the Rubik’s Cube in sixty seconds, and by age ten, they attend their first Tony Robbins success seminar, walking on hot coals, of course.
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At age fifteen, the twins open up competing hot dog stands in New York City – right across the street from each other – and Arnold loses a bet with his twin brother that costs him his hot dog stand as well as his pride.Well, eventually Arnold and Danny become presidents of the nations of Macro and Micro, respectively. Let’s first see how these twins made it into the highest positions of the land, but more importantly, watch what happens when they compare the nominal GDP of their two nations. Then we’ll introduce a superior way to compare the output of an economy.As the years roll on, both young men grow in their success, rising to the top of every company and organization they work for. After twenty years, Arnold and Danny find themselves in the highest position possible in the nations they live in – Arnold is the president of the nation of Macro, and Danny’s the prime minister of the nation of Micro!On New Year’s Eve, they happen to run into each other while attending a royal party hosted by the King of Eden – the twins discover that they are by accident attempting to court the same woman.
Helen is her name, and she also just happens to be the king’s daughter! After greeting each other politely, their competitive nature gets the best of them, and Arnold begins to discuss the biggest challenge they’ve ever been involved in, with an even bigger reward.Here’s the challenge: whoever’s economy has a higher gross domestic product at the end of the year gets to take over half of the other person’s land and marry the king’s daughter. Gross domestic product is the total market value of goods and services produced within the domestic borders of a nation during the year.On New Year’s Eve, the two of them meet up at the royal party, dressed in their absolute best outfit in preparation for the opportunity to ask the king’s daughter to marry him.
Arnold announces that his gross domestic product (or nominal GDP) is $1.5 trillion, while Danny’s is $1.75 trillion.
Once again, just like with the hot dog stand, it looks like Danny is the winner, but the king knows different because the king understands the difference between nominal GDP and real GDP.
Removing the Effects of Rising Prices
Because of the huge reward at stake, the twins agree to defer to the King of Eden, who first begins by asking them what their inflation rate was in the nation that they’re in over the past year. Arnold says inflation was 0% in his nation, while Danny says 5%.’Aha!’ says the king. After reviewing all of the economic statistics, the king makes adjustments to Danny’s gross domestic product numbers by measuring the market value of goods and services produced at the prices that were available in a previous year, thereby removing the effect of rising prices, or what we call inflation.
Nominal vs. Real GDP
Nominal gross domestic product, or nominal GDP, is the total market value of goods and services produced, measured in current dollars. It represents ‘current quantities at current prices.
‘On the other hand, real gross domestic product, or real GDP, is the total market value of goods and services produced, measured in constant dollars. What that means is it represents ‘current quantities at past prices.’When he’s all done with his adjustments (the king, I’m talking about), he tells the twins that Arnold’s real GDP was $1.
5 trillion, and although Danny’s nominal GDP was $1.75 trillion (higher than the other one was), his real GDP was only $1.49999999999 trillion.
Feeling very wounded, quite shocked, but mostly astonished that his twin brother just beat him by about a penny and gained half of his land and the king’s daughter, he storms out of the party, climbs in his Rolls Royce, and heads for the hills.A month later, the entire nation of Eden joins their king in celebrating the wedding of the king’s daughter to President Arnold, and Danny shows up to give his brother love and support, and everyone lives happily ever after.
Two Reasons That Economic Output Can Increase
Okay, so whenever we compare the gross domestic product of a nation from one year to the next, we’re trying to find out what economic output was, but we have to realize that GDP can go up for two reasons.Firstly, it can go up because a nation actually produced more goods and services. Secondly, it can go up simply because prices for goods and services have increased – inflation, in other words.
Think about this for a minute. If a nation produced $500 in nominal GDP in one year and then produced $1,000 in nominal GDP the next year, but the price level doubled (or increased by 100%), then the nominal GDP may look great, but the people in the land are no better off than they were in the first year. The country simply produced the same amount of stuff, but the stuff was twice as expensive.By using real GDP, we discover how much a nation’s output really grew. Danny’s economy had nominal growth but no real growth.
That’s why the King of Eden gave the winnings to Arnold. What’s the real lesson we’ve learned here? Find out how much the economy really grew!
Lesson Summary
Okay, it’s time to review. Gross domestic product, or GDP, is the total market value of goods and services produced within the domestic borders of a nation during the year. Nominal gross domestic product, or nominal GDP, is the total market value of goods and services produced, measured in current dollars.
It represents ‘current quantities at current prices.’ On the other hand, real gross domestic product, or real GDP, is the total market value of goods and services produced, but, listen to this, measured in constant dollars. It represents ‘current quantities at past prices,’ so it removes the effect of inflation.
Using nominal GDP creates a false impression of the amount of output taking place in a nation from one year to the next. How do we account for this? We adjust the nation’s nominal GDP by any increase in the price level that took place. In other words, we adjust GDP for inflation. Economists call the new adjusted number real GDP because it tells us how much production really increased from one year to the next.
Lesson Objectives
After viewing this lesson, you’ll be able to:
- Explain the difference between real and nominal GDP
- Recall factors that contribute to an increase in economic activity
- Understand the shortcomings of nominal GDP
