A country can announce that its GDP rose by 10% and still have a population that is worse off. Nothing dishonest has happened. The figure just has not been corrected for two things that get in the way: rising prices, and a growing number of people to share the output between. This page is about doing those two corrections properly.
📘 What you need to know
Nominal means measured at today’s prices, with no adjustment for inflation.
Real means adjusted for inflation, so it reflects actual output rather than higher prices.
The GDP deflator is the price index used to make that adjustment.
Real GDP = (nominal GDP ÷ GDP deflator) × 100.
Per capita means per person: divide by the population.
Purchasing power parity (PPP) adjusts for the fact that the same money buys different amounts in different countries.
The best measure for comparing living standards between countries is real GNI per capita at PPP.
Why nominal figures mislead
Nominal GDP goes up for two completely different reasons. Either the country made more stuff, or the same stuff got more expensive. From the outside these look identical, and only one of them makes anybody better off.
The two lines start from the same place and describe the same economy. The whole of the growing gap between them is inflation, not extra output.
A quick sense check that works every time: if prices rose 8% and nominal GDP rose 8%, the country produced exactly the same amount as last year. Real growth was zero. If you ever calculate real growth that is bigger than nominal growth, check whether prices fell. If they did not, you have made an arithmetic slip.
Correcting for inflation
The GDP deflator is a price index covering everything included in GDP. It is set to 100 in a chosen base year. A deflator of 115 means prices in general are 15% higher than they were in that base year.
Converting nominal into real
Real GDP = nominal GDP ÷ GDP deflator × 100
Read what the formula is doing. If prices have risen, the deflator is above 100, so you are dividing by something bigger than one and the figure comes down. You are pricing this year’s output as if the base year’s prices still applied, which is the only fair way to compare two years.
Exam vocabulary: “at current prices” means nominal. “At constant prices” means real. If a question asks about a rise in GDP at constant prices, it is asking you to talk about real growth, so genuine extra output.
Correcting for population
Now the second problem. A country’s output can grow 3% while its population grows 4%. Total output is up, but there are more people sharing it, so the average person has less.
Per person
Real GDP per capita = real GDP ÷ population
Per capita figures make comparison between countries possible at all. A large country with a modest standard of living can easily have a bigger total GDP than a small, wealthy one, and comparing the totals would tell you almost nothing about how people live.
Note the word mean. Per capita is total income divided by total people, which quietly assumes it is spread evenly. It is not. Hold onto that thought, because it comes back as a serious criticism two pages from now.
Real GNI per capita, and PPP
Two more refinements, and then you have the best measure the syllabus offers.
First, use GNI rather than GDP. GNI counts the income the country’s people actually receive, including money sent home from abroad and excluding profits sent out by foreign owners. For living standards, income received matters more than output produced.
Second, adjust for purchasing power parity. A dollar does not buy the same amount everywhere. Rent, food, transport and haircuts cost far less in some countries than others, so converting incomes at the market exchange rate makes poorer countries look worse off than they really are. PPP asks a better question: how much can this income actually buy at home?
Measure
What it corrects for
Still ignores
Nominal GDP
Nothing
Inflation, population, ownership, prices abroad
Real GDP
Inflation
Population, ownership, prices abroad
Real GDP per capita
Inflation and population
Ownership and prices abroad
Real GNI per capita
Inflation, population and ownership
Prices abroad
Real GNI per capita at PPP
All four
Distribution, quality of life, unpaid work
WORKED EXAMPLE
An economy has nominal GDP of $250 billion in year 1 with a GDP deflator of 100, and nominal GDP of $276 billion in year 2 with a deflator of 115. Calculate real GDP in each year and comment on what happened. [4]
Step 1: year 1real GDP = (250 ÷ 100) × 100 = 250The deflator is 100, so this is the base year and real equals nominal.Step 2: year 2real GDP = (276 ÷ 115) × 100 = 240Real GDP falls from $250bn to $240bnStep 3: compare the two growth ratesnominal growth = 26 ÷ 250 = +10.4%real growth = −10 ÷ 250 = −4%Nominal GDP rose by more than 10% while the economy actually shrank by 4%. Prices did all the work.
WORKED EXAMPLE
In year 2 the same economy has a population of 30 million and net income from abroad of −$6 billion in real terms. Calculate real GDP per capita and real GNI per capita. [3]
Step 1: real GDP per capita240,000,000,000 ÷ 30,000,000Real GDP per capita = $8,000Step 2: find real GNIreal GNI = 240 + (−6) = $234 billionStep 3: divide by population234,000,000,000 ÷ 30,000,000Real GNI per capita = $7,800The $200 difference per person is income earned inside the country that leaves it.
WORKED EXAMPLE
A basket of goods costs 900 units of local currency in country X and $300 in the USA. Explain what this means for comparing living standards. [3]
Step 1: find the PPP conversion rate900 ÷ 300 = 3 units per PPP dollarStep 2: what that tells youThree units of local currency buy in country X what one dollar buys in the USA.Step 3: apply it
If the market exchange rate is weaker than 3 to the dollar, converting at the market rate understates what people in country X can actually afford.
Converting at PPP gives the fairer comparison of living standardsPPP is why a country can look poor on paper and feel less poor to live in.
💡 Exam tip
Do not forget to multiply by 100. The deflator is an index, so leaving out the 100 gives an answer a hundred times too small.
Round as the question asks, usually to two decimal places, and show the unrounded working first.
Say which measure you are using and why. “Real GNI per capita at PPP, because it strips out inflation, population, ownership and price differences” is a full answer in one line.
Compare growth rates, not levels, when a question asks whether a country improved.
Check the direction of the deflator. Above 100 means prices have risen since the base year, so real must be below nominal.
Keep some criticism ready. Even the best of these measures ignores inequality, and that point is coming up in this topic.
⚠️ Common mix-up
Thinking real GDP means “the correct figure” and nominal means “the wrong one”. Nominal is correct for what it measures. It is just the wrong tool for comparing years.
Multiplying by the deflator instead of dividing. That would add inflation on top of inflation.
Assuming rising GDP per capita means everyone is better off. It is a mean, and means hide a lot.
Confusing the GDP deflator with the CPI. Both are price indices, but the deflator covers everything in GDP while the CPI tracks a basket of consumer goods.
Using market exchange rates for living standard comparisons. That is exactly the problem PPP exists to solve.
Mixing up billions and millions mid-calculation. Write the zeros out when you divide by population.
Up next: The Business Cycle, which is what real GDP actually does over time: rising, stalling, falling and recovering around a longer term trend.
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