Real vs Nominal GNP:"Deflating" GNP by a Price Index

In defining GNP, we measured the dollar value of goods and services using the measuring rod of market prices for oranges, apples, machines, and other commodities. But prices change over time, as inflation generally sends prices upward year after year. Who would want to measure things with a rubber yardstick-one that stretches in your hands from day to day-rather than a rigid yardstick?
   The problem of changing prices is one of the problems economists have to solve when they use money as their measuring rod. Clearly, we want a measure of the nation’s output and income that uses an invariant yardstick.

   How can this be done? Economists can repair most of the damage wrought by the elastic yardstick by using a price index.1 (We first encountered price indexes in Chapter 5. A full discussion will follow in Chapter 14.)

   A 1929-1933 comparison will illustrate the process by which we use a price index number to “deflate” a current or “nominal GNP, ” converting it into “real GNP.” Real GNP measures the total quantity of output, while nominal GNP measures the current dollar value of output. The ratio of nominal GNP to real GNP is the “price of GNP,” which is called the GNP deflator.

   Table 6-1 gives the actual 1929 and 1933 nominal GNP figures of $104 and $56 billion. It shows a 45 percent drop in nominal GNP from 1929 to 1933, but the government estimates that prices on average dropped about 23 percent in the Depression. Using 1929 as a base of 100, this means that the 1933 price index was about 77. So our $56 billion 1933 GNP was really worth much more than half the $ 104 billion GNP of 1929.

   How much more? Table 6-1 divides nominal GNP by the GNP deflator to obtain real GNP, or GNP in 1929 prices. This calculation shows that real GNP fell to only seven-tenths of the 1929 level: in terms of 1929 prices, or dollars of 1929 purchasing power, real GNP fell to $73 billion. Hence, part of the near~ halving shown by the nominal GNP was due to the optical illusion of the shrinking price yardstick.

   Figure 6-1 shows in black the history of nominal GNP (expressed in the actual dollars and prices that were current in each historical year). Then, for comparison, the real GNP (expressed in 1982 dollars) is shown in red.

   Note that part of the increase in nominal GNP over the last half-century is really illusory, being due merely to inflation of the price units of our money yardstick.

To summarize:
Nominal GNP represents the total money value of goods and services produced in a given year, where the values are in terms of the market prices of each year. Real GNP corrects nominal GNP by valuing output in terms of the prices of a base year, creating a constant-dollar measure of output. Because we define the GNP deflator as the price of GNP, we have:

Real GNP=nominal GNP/GNP deflator