Potential output (also known as “natural gross domestic product”) in economics refers to the highest amount of real gross domestic product (potential output) that may be sustained over time. Actual output occurs in the real world, whereas potential output depicts the highest level that could be reached.
What is the formula for calculating natural real GDP?
In general, real GDP is calculated by multiplying nominal GDP by the GDP deflator (R). For instance, if prices in an economy have risen by 1% since the base year, the deflated number is 1.01. If nominal GDP is $1 million, real GDP equals $1,000,000 divided by 1.01, or $990,099.
What exactly is the distinction between real and natural GDP?
There are many other ways to quantify gross domestic product (GDP), including real GDP and potential GDP, but the numbers are often so similar that it’s impossible to tell the difference. Because potential GDP is predicated on continuous inflation, whereas real GDP can change, real GDP and potential GDP address inflation differently. Potential GDP is an estimate that is frequently reset each quarter by real GDP, whereas real GDP depicts a country’s or region’s actual financial situation. Because it is predicated on a constant rate of inflation, potential GDP cannot increase any further, while real GDP can. These GDP metrics, like the inflation rate, treat unemployment as a constant or a variable.
What does real GDP’s natural log mean?
This semester, I’m preparing for my undergraduate growth course (which uses an AWESOME book, by the way). Because our econ majors at UH are not required to take calc, I have to ease them into a few topics throughout the course. Using logs to show and then assess economic progress is one of them. This is a collection of notes I started writing to help students understand the ideas.
This could be useful if you’re a teacher. This might be useful if you’re interested in growth but are afraid of arithmetic. It will kill around 10 minutes and/or help you fall asleep if you have nothing else to do.
We’re interested in real GDP per capita as a gauge of living standards. The absolute value of real GDP per capita isn’t something we worry about because it depends on how we calculate price indices, base years, and other factors. What we’re interested in is how quickly economies grow. This is equivalent to saying that whether you start at 150 pounds or 68 kilos, if your weight increases by 5% per year, you will gain weight.
We always plot real GDP per capita in logs to view those growth rates and do some quick analysis. When I say log, I’m referring to the natural kind. There are a lot of fascinating ways to explain how natural logs work, but this isn’t one of them. For the time being, we’ll take it on faith that natural logs work as I claim.
Calculate the natural log of GDP per capita for each year and plot it against the year. The image below is an example of real GDP per capita plotted using the grey line for India.
Natural logs have a number of advantages that are ideal for our needs. When they’re used, each step up the y-axis corresponds to a 1% change in real GDP per capita. For example, increasing real GDP per capita from 7.0 to 7.5 is a 65 percent increase. The increase in real GDP per capita from 7.5 to 8.0 is likewise a 65 percent increase. This is true even when the GDP per capita increases from $1,096 to $1,800 from 7.0 to 7.5, and from $1,800 to $2,980 from 7.5 to 8.0. We can visualize % increases rather than absolute increases by plotting things in natural logs.
Even more entertaining is the fact that, thanks to this attribute, we can simply determine the average growth rate between two years. The slope of the straight line connecting the two end points is the average growth rate over two years. I’ve overlaid the computation of the growth rate for numerous sub-periods, as well as the average growth rate from 1950 to 2010, in the chart for India.
Connect the two end points, for example, from 1950 to 2010, then get the slope of the line. This can be done mathematically as follows:
You repeat the process for the other sub-periods, but this time utilizing the end points from those time periods. So, from 1950 to 1975, growth was 2.0 percent on average, -3.0 percent from 1975 to 1985, and 5.2 percent from 1985 to 2010.
Why did you choose certain sub-periods over others? They were chosen only because they appeared to be obvious break points. There isn’t a formula for determining which sub-periods should be calculated. It just seems to make sense “Around 1985, for example, “something distinct” happened that distinguished that time apart from the others. If you wanted to, you could calculate the growth rate from 1972 to 2003. You want to dispute with me that the period from 1985 to 2010 should be divided into pre-2003 and post-2003 sub-periods again? Okay. I’m afraid I can’t tell you that you’re mistaken.
The average growth of the three sub-periods I calculated appears to be quite similar to the real growth. That is, the real path of GDP per capita does not deviate significantly from the straight line we used to compute average growth from 1950 to 1975. What exactly do I mean by that? “A long way away”? I’m not trying to be technical; I’m simply guessing.
However, compare those three sub-periods to the entire period from 1950 to 2010. We calculate average growth at 2.5 percent, but for practically the entire period, the straight line that gives us that result is well above the actual real GDP per capita. Average growth from 1950 to 2010 does not provide a particularly clear picture of India’s growth experience throughout history, as there appear to be three distinct periods.
That isn’t to say that 2.5 percent is incorrect. It’s the same as the average growth rate between 1950 and 2010. If you started with $798 in real GDP per capita in 1950 and added 2.5 percent growth, you’d end up with $798.
which is only a few cents short of the actual worth of $3,596. However, the route from 1950 to 2010 appears to be considerably different, with an average annual growth rate of 2.5 percent, when compared to the actual path of real GDP per capita in India during this time period.
Regardless, periods when the average growth rate is very close to the actual growth rate of real GDP per capita will pique our interest (the straight line is close to the gray line). As previously said, 1950 to 1975, or arguably 1985 to 2010. These times may indicate what we’ll refer to as “BGPs stand for “balanced growth paths.”
We’re interested in BGPs because our growth theories imply that in the absence of substantial reform, a country will inevitably end up on one. That is, in the absence of a large shock to a basic feature of the economy, an economy’s real growth will likely to be near to average growth. Furthermore, if we notice distinct BGPs, it means that something essential has changed.
India’s picture shows that the time from 1950 to 2010 was not a BGP for the country. From 1950 through 1975, one could say one thing, and then in 1975, something fundamentally different happened. What was it, exactly? We can’t tell based on this graph. To make a decision, we’d have to look at other statistics on India, and our theory might point us in the right direction. Something appears to have fundamentally altered in 1985, when India switched to what appears to be a new BGP. We’d have to look at more data to figure out what had changed.
To be clear, what we see in the graph is required but insufficient to prove that India was on a BGP. That is, there are other characteristics that must be met in order to identify a period of time as being historical “There could be other reasons why India was not on a BGP from 1975 to 1985, for example, despite real growth being close to average. However, looking at a statistic like this indicates where we should begin our search.
To be even more thorough, simply because the majority of our ideas predict that countries will end up on a BGP in the absence of a huge shock does not guarantee they are correct. It’s possible that our theories are utterly incorrect. Perhaps nothing essential changed in 1975 or 1985, and all that happened was that India had a string of bad luck. Perhaps we’re exaggerating the significance of these long periods of equal growth rates.
What does nominal GDP mean?
Nominal GDP is a measurement of economic output in a country that takes current prices into account. In other words, it does not account for inflation or the rate at which prices rise, both of which might overstate the growth rate.
What is the difference between nominal and real GDP, and how do you know?
The distinction between nominal GDP and real GDP is that nominal GDP measures a country’s production of final goods and services at current market prices, whereas real GDP measures a country’s production of final goods and services at constant prices throughout its history.
How can you calculate real GDP using price and quantity alone?
What proportion of the growth in GDP is due to inflation and what proportion is due to an increase in actual output? To answer this topic, we must first examine how economists compute Real Gross Domestic Product (RGDP) and how it differs from Nominal GDP (NGDP). The market value of output and, as a result, GDP might rise due to increased production of products and services (quantities) or higher prices for commodities and services. Because the goal of assessing GDP is to see if a country’s ability to generate larger quantities of goods and services has changed, we strive to exclude the effect of price fluctuations by using prices from a reference year, also known as a base year, when calculating RGDP. When calculating RGDP, we maintain prices fixed (unchanged) at the level they were in the base year. (1)
Calculating Real GDP
- The value of the final products and services produced in a given year represented in terms of prices in that same year is known as nominal GDP.
- We use current year prices and multiply them by current year quantities for all the goods and services generated in an economy to compute nominal GDP. We’ll use hypothetical economies with no more than two or three goods and services to demonstrate the method. You can imagine that if a lot more items and services were included, the same principle would apply.
- Real GDP allows for comparisons of output volumes throughout time. The value of final products and services produced in a given year expressed in terms of prices in a base year is referred to as real GDP.
- For all the products and services produced in an economy, we utilize base year prices and multiply them by current year amounts to calculate Real GDP. We’ll use hypothetical economies with no more than two or three goods and services to demonstrate the method. You can imagine that if a lot more items and services were included, the same principle would apply.
- Because RGDP is calculated using current-year prices in the base year (base year = current-year), RGDP always equals NGDP in the base year. (1)
Example:
Table 3 summarizes the overall production and corresponding pricing (which you can think of as average prices) of all the final goods and services produced by a hypothetical economy in 2015 and 2016. The starting point is the year 2015.
Year 2016
Although nominal GDP has expanded tremendously, how has real GDP changed throughout the years? To compute RGDP, we must first determine which year will serve as the base year. Use 2015 as the starting point. Then, in 2015, real GDP equals nominal GDP equals $12,500 (as is always the case for the base year).
Because 2015 is the base year, we must use 2016 quantities and 2015 prices to calculate real GDP in 2016.
From 2015 to 2016, RGDP increased at a slower rate than NGDP. If both prices and quantity rise year after year, this will always be the case. (1)
Is nominal GDP better than real GDP?
As a result, whereas real GDP is a stronger indication of consumer spending power, nominal GDP is a better gauge of change in output levels over time.
What makes real GDP more precise?
Real GDP, also known as “constant price GDP,” “inflation-corrected GDP,” or “constant dollar GDP,” is calculated by isolating and removing inflation from the equation by putting value at base-year prices, resulting in a more accurate depiction of a country’s economic output.
What’s the difference between nominal GDP and PPP GDP?
Macroeconomic parameters are crucial economic indicators, with GDP nominal and GDP PPP being two of the most essential. GDP nominal is the more generally used statistic, but GDP PPP can be utilized for specific decision-making. The main distinction between GDP nominal and GDP PPP is that GDP nominal is the GDP at current market values, whereas GDP PPP is the GDP converted to US dollars using purchasing power parity rates and divided by the total population.
Why do economists use logarithms?
Let me start by going over compound interest rates quickly. If you invest an amount for one year at an interest rate of r percent, you will have an amount at the end of the year. For example, if you get a 4% return, your interest may be compounded, meaning you get your money back plus 2% after six months, and then you can earn 2% interest on both your original investment and the first six months’ interest: Your money would have increased 4.04 percent at the end of the year if you had an interest rate of r = 4% compounded twice a year like this. Quarterly compounded, or 4.06 percent at the end of the year. As the frequency of compounding n increases, the formula converges to a certain function, with the limit beingwhere e is a peculiar number (roughly equal to 2.72) that possesses this and a number of other astonishing qualities. Thus, if you earn r percent interest that is compounded annually, your money will have increased by at the end of the year. If r = 4%, for example, continuous compounding would yield 4.08 percent at the end of the year, somewhat higher than the 4.06 percent from quarterly compounding or the 4.0 percent from no compounding.
Taking natural logarithms is the inverse of the preceding operation: or, because the log of a ratio is the difference of the logs,
In other words, calculating a rate of return on a holding by subtracting the log of the price in year 2 from the log of the price in year 1 is the same as calculating a rate of return on the holding expressed as a continuously compounded rate.
The continuously compounded return is nearly equal to the noncompounded return for low values of r, hence the log difference is nearly equal to the percentage change. The percentage change in the above example is, whereas the log change is. So, if you see a graph that is measured in logs, a change of 0.01 on that scale equates to a 1 percent rise quite precisely. When plotted in logs, a graph that is a straight line through time correlates to annual growth at a constant percentage rate.
When compared to looking at simple percent changes, using logs, or summarizing changes in terms of continuous compounding, provides a number of advantages. For example, if your portfolio increases by 50% (from $100 to $150) and subsequently drops by 50% (from $150 to $75), you aren’t back where you started. When you compute your average percentage return (in this case, 0%), you’ll see that it’s not a very useful summary of the fact that you ended up 25% below where you started. In contrast, if your portfolio increases by 0.5 in logarithmic terms and subsequently decreases by 0.5 in logarithmic terms, you are back to square one. The difference in log price between the time you acquired it and the time you sold it, divided by the number of years you kept it, is the average log return on your portfolio.
When it comes to analyzing economic data, logarithms are typically far more beneficial. Here’s a graph showing the overall U.S. stock price index, which dates back to 1871. Nothing can be seen in the first century when plotted on this scale, yet the most recent decade looks to be madly erratic.