Define and distinguish between real and nominal GDP. Explain why the distinction is important to economists.

Question

What will be an ideal response?

Answer 1

Real GDP (or GDP in constant dollars) is a measure of the output of final goods and services produced in the domestic economy during a specific time period. It measures output in dollars of constant value. Therefore, it corrects for the effects of inflation. Real GDP will increase if there is an increase in the actual output of goods and services, such as more automobiles, more computers, more Internet access time, or more new economic textbooks. Nominal GDP (or GDP in current dollars, or money GDP) is a measure of output of final goods and services at current prices produced in the domestic economy during a specific time period. It measures final sales using dollars of current (noninflation corrected) spending power. It can increase because of an increase in real output or because of an increase in the prices of final goods and services. Economists use real GDP as a more accurate measure of the true state of the economy, in that it tells us whether there are more or fewer actual final goods and services in the economy. Nominal GDP can be misleading in this regard. An example of this is the case of stagflation; rising prices, combined with falling output of final goods and services, may result in rising nominal GDP and falling real GDP. The decrease in real GDP is a better indicator of the sluggish economy.