The GDP calculation discussed in the previous post is a fine way to compare different areas at the same point in time. It does, however, have two weaknesses.
The first weakness is that the value of the unit of account changes. Anyone living long enough knows that over time the dollar bill can purchase less as time passes. The nominal price level increases, so that makes it difficult to compare one year to another and less useful the more time that passes. If economists wanted to look at growth in one country that had a GDP of one trillion in 1995 and ten trillion in 2014, does it make sense for her to say that in the intervening years, the economy of that country had grown ten times? The answer is “no” because we do not have a measure of the inflation between those years. First, the economist would have to find the rate of inflation so that those two numbers are being compared in terms of dollars that have the same value. Once this adjustment is made, then the economist can compare the overall size of the economy more accurately. This measurement of calculating the GDP as if prices did not change is the Real GDP (Krugman & Wells, 2013, p. 199). Stating measurement of GDP in terms of Real GDP allows measurement of the same country across time.
The second weakness of the nominal GDP obtained from addition of the inputs is that it is not easily used to compare across countries. A good example of the comparison is that between the United States and China. China recently passed Japan to become the world’s second largest economy in terms of the nominal GDP, and they are closing in on the United States in pure dollars. Politicians have raised the specter of a rising China as a competitor to the US. The problem is that such comparisons rely on the innumeracy of the electorate. Though the China is approaching the US in terms of overall size, the population of the country is roughly four times that of the United States. That means that if you took the final value of the goods and services that accrued to China and divided it by the population of China, and made the same calculation for the United States, the value of these goods and services per each individual would be almost four times higher for those in the United States. This measurement is the GDP per Capita measurement (Krugman & Wells, 2013, p. 199). Looking at GDP in this manner allows economists to compare countries of different population size. If the measurement is then put in constant dollars, economist can then look at countries at a point in time and then across time. A big drawback of this method is that it assumes that growth accumulated to all the individuals in a country at the same rate, though it is easy shorthand for looking at the overall rate of a country’s growth concerning how it is experienced by the population.
Krugman, P. & Wells, R. (2013). Macroeconomics. New York, NY : Worth Publishers