Real GDP, Nominal GDP, and the Deflator

Nominal GDP adds up all the final goods and services a country produces, valued at the prices in effect that year. That means nominal GDP can rise even if the country makes nothing new, just because prices went up. To see actual growth in production, economists hold prices fixed at some base year and recalculate output using those frozen prices. That recalculated number is real GDP. Whatever gap remains between nominal and real GDP is pure price change, not more stuff.

The GDP deflator is the tool that measures that price change. It is defined as nominal GDP divided by real GDP, times 100. A deflator of 110 means prices overall are 10 percent higher than they were in the base year. Rearranging the same relationship lets you solve for real GDP: divide nominal GDP by the deflator and multiply by 100. These two formulas are really one idea viewed from two directions, and the base year itself always has a deflator of exactly 100, since nominal and real GDP are identical there.

This topic sits right between measuring output and measuring price levels, the two indicators that, together with unemployment, define the business cycle. Real GDP feeds directly into growth rates and recession calls, since a recession is a decline in real GDP, not nominal GDP. The deflator itself is one of several price-level measures used to track inflation, alongside the CPI, so this topic is the hinge connecting output measurement to the inflation unit that follows.