Two ways GDP can grow
In Topic 2.1 you met GDP: the market value of all final goods and services produced in a country in a period. “Market value” means quantity × price. So GDP measured in money can rise for two different reasons:
- The economy produces more goods and services (quantities rise).
- The prices of those goods and services rise.
Only the first reason makes people better off in terms of goods available. If every price doubled and output stayed the same, GDP in money would double, but nobody would have a single extra loaf of bread. Economists therefore use two measures.
- Nominal GDP measures output using current prices: each year’s quantities times that same year’s prices. It tells you how much is spent on final output.
- Real GDP measures output using constant prices: each year’s quantities times the prices of one fixed year. It tells you how much is produced, because the effect of changes in the overall price level has been removed.
The fixed year whose prices are used is the base year. You met base years with the CPI in Topic 2.4; the idea is the same.
The calculations
Nominal GDP in year t = Σ (price in year t × quantity in year t)
Real GDP in year t = Σ (price in the base year × quantity in year t)
(Σ means “add up over all final goods and services”.)
Because real GDP holds prices fixed, it can only change when quantities change. Nominal GDP changes when either prices or quantities change.
The GDP deflator is a price index built from these two numbers:
GDP deflator = (nominal GDP ÷ real GDP) × 100
Rearranging gives the formula you will use most:
Real GDP = (nominal GDP ÷ GDP deflator) × 100
In the base year nominal and real GDP are equal, so the deflator is 100. A deflator of 112 means the prices of the goods and services in GDP are, on average, 12% higher than in the base year.
Because the deflator is a price index, you can find an inflation rate from it with the formula from Topic 2.4: (new deflator − old deflator) ÷ old deflator × 100.
Worked example 1: real GDP and the deflator from prices and quantities
Valdoria (the fictional country from Topic 2.4, currency the valda, VD) has a statistics office that trains new staff on a toy economy with only three final goods. Quantities are in millions; prices are in VD, so GDP values are in VD million. The base year is 2023. All data are fictional.
| Good | 2023 quantity | 2023 price | 2024 quantity | 2024 price | 2025 quantity | 2025 price |
|---|---|---|---|---|---|---|
| Rice (sacks) | 100 | VD 20 | 104 | VD 22 | 106 | VD 24 |
| Bicycles | 20 | VD 150 | 21 | VD 156 | 22 | VD 165 |
| Phones | 5 | VD 400 | 6 | VD 380 | 8 | VD 350 |
Question. Calculate nominal GDP, real GDP (2023 prices) and the GDP deflator for each year. Then calculate the growth rate of nominal GDP, the growth rate of real GDP and the inflation rate (from the deflator) for 2024 and 2025.
Step 1: nominal GDP (each year’s quantity × the same year’s price).
- 2023: 100(20) + 20(150) + 5(400) = 2,000 + 3,000 + 2,000 = VD 7,000 million
- 2024: 104(22) + 21(156) + 6(380) = 2,288 + 3,276 + 2,280 = VD 7,844 million
- 2025: 106(24) + 22(165) + 8(350) = 2,544 + 3,630 + 2,800 = VD 8,974 million
Step 2: real GDP (each year’s quantity × the 2023 price).
- 2023: same as nominal = VD 7,000 million
- 2024: 104(20) + 21(150) + 6(400) = 2,080 + 3,150 + 2,400 = VD 7,630 million
- 2025: 106(20) + 22(150) + 8(400) = 2,120 + 3,300 + 3,200 = VD 8,620 million
Step 3: GDP deflator = nominal ÷ real × 100.
- 2023: 7,000 ÷ 7,000 × 100 = 100 (base year)
- 2024: 7,844 ÷ 7,630 × 100 = 102.80
- 2025: 8,974 ÷ 8,620 × 100 = 104.11
Step 4: growth rates.
| 2024 | 2025 | |
|---|---|---|
| Nominal GDP growth | (7,844 − 7,000) ÷ 7,000 × 100 = 12.06% | (8,974 − 7,844) ÷ 7,844 × 100 = 14.41% |
| Real GDP growth | (7,630 − 7,000) ÷ 7,000 × 100 = 9.00% | (8,620 − 7,630) ÷ 7,630 × 100 = 12.98% |
| Inflation (deflator) | (102.80 − 100) ÷ 100 × 100 = 2.80% | (104.11 − 102.80) ÷ 102.80 × 100 = 1.27% |
Interpretation. Spending on output grew by 12.06% in 2024, but output itself grew by only 9.00%; the rest of the rise in spending came from higher prices. Notice that phones became cheaper, yet the deflator still rose, because rice and bicycles became dearer.
Check. Nominal growth is roughly real growth plus inflation: 9.00% + 2.80% = 11.80%, close to 12.06%. The shortcut is only approximate; the exact figures come from the real GDP values.
Worked example 2: using the deflator to find real GDP
Statistical offices do not publish prices and quantities for every good. They publish nominal GDP and a deflator. Here are Valdoria’s (fictional) national accounts, with base year 2023.
| Year | Nominal GDP (VD billion) | GDP deflator (2023 = 100) |
|---|---|---|
| 2022 | 380.0 | 95 |
| 2023 | 420.0 | 100 |
| 2024 | 462.0 | 105 |
| 2025 | 470.4 | 112 |
| 2026 | 494.5 | 115 |
Question. (a) Calculate real GDP for each year. (b) Calculate the real growth rate for each year from 2023. (c) In which year did nominal GDP rise while real GDP fell? Explain. (d) Why is real GDP larger than nominal GDP in 2022?
(a) Real GDP = nominal ÷ deflator × 100.
- 2022: 380 ÷ 95 × 100 = VD 400 billion
- 2023: 420 ÷ 100 × 100 = VD 420 billion
- 2024: 462 ÷ 105 × 100 = VD 440 billion
- 2025: 470.4 ÷ 112 × 100 = VD 420 billion
- 2026: 494.5 ÷ 115 × 100 = VD 430 billion
(b) 2023: (420 − 400) ÷ 400 × 100 = 5.00%. 2024: (440 − 420) ÷ 420 × 100 = 4.76%. 2025: (420 − 440) ÷ 440 × 100 = −4.55%. 2026: (430 − 420) ÷ 420 × 100 = 2.38%.
(c) 2025. Nominal GDP rose by (470.4 − 462) ÷ 462 × 100 = 1.82%. But the deflator rose by (112 − 105) ÷ 105 × 100 = 6.67%. Prices rose faster than spending, so the quantity of output fell. Anyone who looked only at nominal GDP would have missed a fall in production.
(d) 2022 is before the base year, and the price level was lower then (deflator 95). Real GDP values 2022 output at the higher 2023 prices, so it comes out larger than nominal GDP.
Why base-year prices can overstate growth
Real GDP depends on which year’s prices you use. Go back to the toy economy in Worked example 1 and value every year’s output at 2025 prices instead of 2023 prices.
| 2023 | 2024 | 2025 | |
|---|---|---|---|
| Real GDP at 2023 prices (VD million) | 7,000 | 7,630 | 8,620 |
| Real GDP at 2025 prices (VD million) | 7,450 | 8,061 | 8,974 |
For example, 2023 at 2025 prices = 100(24) + 20(165) + 5(350) = 2,400 + 3,300 + 1,750 = 7,450.
Measured real growth now changes: 2024 growth is (8,061 − 7,450) ÷ 7,450 × 100 = 8.20% at 2025 prices, against 9.00% at 2023 prices. The quantities are identical; only the price weights differ.
Why is the earlier base year’s figure higher? Phone output grew fastest (from 5 to 6 million, 20%, in 2024) while phone prices fell (from VD 400 to VD 350 over the two years). The 2023 prices value each phone at VD 400, so the fast-growing good gets a large weight. In real economies the same pattern is common: goods whose output grows quickly (often technology) tend to become relatively cheaper. Weighting them at old, high prices overstates real GDP growth, and the further the base year is in the past, the larger the problem can become.
For this reason statistical agencies do not simply use one fixed base year. They use other methods, such as chain weighting, which keeps updating the price weights so that each year’s growth is measured with recent prices. For example, the United States reports real GDP in “chained dollars”. You do not need to calculate a chain-weighted index; you need to explain why the fixed base-year method can overstate growth.
Background: the GDP deflator and the CPI. Both are price indices, but they cover different things. The deflator covers all final goods and services produced in the country (including investment goods and government purchases) and excludes imports. The CPI covers a fixed basket of goods and services bought by consumers, including imported ones. The deflator’s weights also change with what is produced each year, so it is not tied to a fixed basket the way the CPI is (Topic 2.4).
Common misconceptions
- “Nominal GDP rose, so the economy produced more.” Not necessarily. In Worked example 2, nominal GDP rose in 2025 while output fell. Use real GDP to judge production.
- “Real GDP is always smaller than nominal GDP.” Only when the deflator is above 100. When the price level is below its base-year level (for example, before the base year if prices have been rising, or after deflation), real GDP is larger.
- Multiplying instead of dividing. Real GDP = nominal ÷ deflator × 100. Multiplying by the deflator makes the number bigger, which removes nothing.
- Inverting the deflator. The deflator is nominal ÷ real, not real ÷ nominal.
- Using current prices for real GDP. Real GDP always uses the base year’s prices, whatever year’s quantities you are valuing.
- Reading the deflator as an inflation rate. A deflator of 112 means prices are 12% above the base year. The inflation rate is the percentage change in the deflator from one year to the next (6.67% in 2025 in Worked example 2).
- “Real growth = nominal growth − inflation exactly.” It is a close approximation when rates are small. For exact answers, calculate real GDP first.
- “Base-year real GDP is a perfect measure.” Fixed base-year prices can overstate growth; that is why agencies use chain weighting.
Where this leads
Real GDP is the measure of output used from now on. In Topic 2.7, Business Cycles, you will track real GDP over time to find recessions, expansions and output gaps. Next, try the practice questions, then use the revision notes and the checklist to consolidate. When you are ready, move on to Business Cycles.
Quick questions
Is real GDP always smaller than nominal GDP?
No. In the base year they are equal. Real GDP is smaller than nominal GDP only when the price level is above its base-year level (deflator above 100). When the price level is below its base-year level (deflator below 100), real GDP is larger. That is usual for years before the base year if prices have been rising, and it can also happen after enough deflation.
Do I need to calculate chain-weighted real GDP?
No. You need to calculate real GDP using base-year prices and explain why that method can overstate growth. The chain-weighting method agencies use instead is background only.