The post How to Calculate Marginal Cost appeared first on Quickonomics.

]]>First, we have to calculate the change in cost. In most cases, costs increase or decrease according to the level of output. A higher output usually results in higher costs while a lower output results in lower costs. The reason for this is the presence of variable costs. Variable costs are directly related to the level of output that is being produced and therefore increase or decrease accordingly. In addition to that, step costs (or step fixed costs) can also push costs, whenever a specific level of output is reached. Now, calculating the change in cost is really simple. All we have to do is take the cost after the change in output (i.e. new cost) and subtract it from the cost before the change (i.e. old cost). This results in the following formula:

*Change in cost = new cost – old cost*

To give an example, let’s assume you own a burger restaurant: *Deli Burger*. Yesterday you sold 100 burgers, which resulted in total costs of USD 300. Today you sell 102 burgers. Therefore you need two additional patties, more buns, more lettuce, etc. As a result, your total costs increase to USD 304. Hence the change in cost is USD 4.00 (304 – 300).

Next, we have to calculate the change in quantity. A change in the level of output is synonymous with a change in quantity. That is, when the level of output increases, the quantity supplied of a good or service increases and vice versa. Computing a change in quantity works just like computing a change in cost. All we need to do is take the quantity after the change in output (i.e. new quantity) and deduct that from the quantity before the change (i.e. old quantity). This gives us the following formula:

**Change in quantity = new quantity – old quantity **

In the case of *Deli Burger, *the change in quantity is 2 burgers (102 -100). Please note, even though marginal cost is defined as the change in cost incurred by producing *one* more unit of a good or service, we can still calculate it for any given number of additional units.

Finally, we can calculate marginal cost by dividing the change in cost by the change in quantity. To understand why we do this, just take another look at the definition: marginal cost is *the cost incurred by producing one more unit of output*. In other words, it is the increase in cost *per* additional unit. However, because it depends on the change in cost and the change in quantity, marginal cost can vary as the current level of output changes. That means, the marginal cost of selling 11 instead of 10 units may be different from the marginal cost of selling 101 units instead of 100 (even though the change in quantity is the same). Hence, we can use the following formula to calculate marginal cost:

**Marginal cost = change in cost / change in quantity**

Going back to our *Deli Burger* example, let’s calculate marginal cost for your 101^{st} and 102^{nd }burgers. If we plug the numbers from above into our formula we get the following equation: USD 4.00 / 2 burgers = USD 2.00. Hence, the marginal cost of producing two additional burgers at this point is USD 2.00 per burger.

Marginal cost is defined as the cost incurred by producing one more unit of a product or service. This is an important concept in economic theory because it is one of the foundations of profit maximization. We can calculate marginal cost by following three simple steps: (1) calculate change in costs, (2) calculate change in quantity, and (3) divide change in cost by change in quantity.

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]]>The post The Four Types of Economic Utility appeared first on Quickonomics.

]]>Form utility is created by the design of the product or service itself. The more specifically a good or service is targeted towards customer needs and desires, the higher its perceived added value (i.e. form utility) will be. In other words, form utility is obtained by transforming customer needs into products or services. To do this, companies analyze their target markets and survey potential customers to find out what they need. This information can then be used to align product features with actual customer needs. Thus, form utility can be created through things such as high quality materials, ergonomic design, or a wide selection of options to chose from.

To give an example of form utility, think of a car manufacturing company. We’ll call it *Super Cars*. In theory, this company could sell all the parts of their cars separately. However, by assembling the parts (and actually manufacturing cars) *Super Cars* adds significant value for their customers and thereby increases form utility.

Place utility can be obtained through the process of making a good or service more easily available to potential customers. The easier it is to purchase a product, the more attractive it becomes. Thus, place utility has a lot to do with distribution channels and the physical locations at which goods or services are sold. Additionally, some economists argue that even things like the discoverability of the product on the internet through search engine optimization has an effect on place utility. After all, a wide variety of goods and services can be bought online these days.

Going back to our example from above, let’s assume *Super Cars* is an American company. If its cars are sold exclusively within the US, buying a* Super Car* is obviously not very attractive for Europeans. However, if the company decides to open dealerships across Europe and sell *Super Cars* overseas, availability (i.e. place utility) of its cars for European customers increases.

Time utility is created by providing easy availability of a good or service at the time when customers need or want it. The more easily and quickly a product can be purchased (and used) at that time, the higher its perceived time utility is. In addition to that, time utility is always high in times of scarcity. Hence, a company’s supply chain management has a significant impact on time utility. Among others, this includes processes such as logistics and delivery as well as storage. Companies are constantly improving their supply chain management, which has led to services such as same-day delivery and 24/7 availability.

In the case of *Super Cars*, one way to increase time utility would be to reduce delivery times. Customers often have to wait several weeks or even months for a new car. However, many of them need their vehicles as soon as possible. Thus, if *Super Cars* manages to reduce delivery times by even just a few days, its cars become more attractive to potential customers.

Possession utility describes the benefits that can be derived from owning and using a specific product. Generally speaking, the more “useful” a product is to an individual, the higher its possession utility will be. In some cases – especially according to marketing theory – the term possession utility is also used in the context of facilitating possession, i.e. through easy payment methods such as credit cards or leasing contracts. The reasoning behind this is that a simpler acquisition process usually leads to a higher perceived value of a good or service.

For example, possession utility can be created whenever a client is handed the keys to their new *Super Car*. Simply because from that moment they have possession of the car and are free to do whatever they want to do with it. Additionally, *Super Cars* can create possession utility by offering leasing contracts, which make it easier for potential customers to actually get access to a new car.

In the field of behavioral economics the term utility refers to the perceived value (i.e. usefulness) an individual receives when they purchase a good or service. There are four different types of utility: form, place, time, and possession utility. Form utility is created by the design of the product or service itself. Place utility can be obtained through the process of making a good or service more easily available to potential customers. Time utility is created by providing easy availability of a good or service at the time when customers need or want it. And last but not least, possession utility describes the benefits that can be derived from owning and using a specific product.

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]]>The post How to Calculate a Linear Supply Function appeared first on Quickonomics.

]]>In its most basic form, a linear demand function looks as follows: *y = mx + b*. In this case, *x* and *y* represent the independent and dependent variables. Meanwhile, *m* shows the slope of the function and *b* represents its y-intersect (i.e. the point where the function intersects the y-axis). To illustrate this, let’s calculate the supply function of an imaginary candy bar factory, called *SuperCandy*. We will call the function *S _{q}*, with

To calculate a linear supply function we need to know the quantities supplied for at least two different prices. This allows us to create what we call two ordered pairs *(x _{1},y_{1})* and

With the two ordered pairs and the basic linear function, we can now calculate the slope of the supply function. The slope is defined as the change in price, divided by the change in quantity supplied between two points (i.e. the two ordered pairs). We can use the following formula to calculate it: m = (*y _{2 }–*

Now that we have calculated the slope of the function, we can plug that value into the initial function (instead of m). Then all we need to do is plug in the values of one ordered pair, which allows us to calculate the y-intersect of the function (by solving the equation for b). Revisiting our example, we can update the initial linear function to include the slope (i.e. *S _{q} = 0.004q + b). *Next, we simply replace

Last but not least, we can use the second ordered pair to double-check our result. Please note that this step is optional, however it might come in handy during exams or quizzes. All we need to do is plug the values of the second pair into the supply function we just calculated and see if the equation is still correct. If we do this with the values from our example above (750, 1) we get the following equation: 1 = 0.004*750 – 2. As you can see, this equation still holds true. Thus, the supply function we calculated above must be correct.

In economics, we often use linear supply and demand functions to make calculations. This makes it easier to work with them, which in turn allows us to analyze and understand a wide range of basic economic concepts. To calculate linear supply functions, we can follow a simple four step process: (1) Write down the basic linear function, (2) find two ordered pairs of price and quantity, (3) calculate the slope of the supply function, and (4) calculate its y-intercept.

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]]>The post How to Calculate Producer Surplus appeared first on Quickonomics.

]]>In the following paragraphs, we will take a closer look at how to calculate producer surplus. To do this, we will follow a simple 4-step process: (1) draw the supply and demand curves, (2) find the market price, (3) connect the price axis and the market price, and (4) calculate the area of the lower triangle.

The calculation of producer surplus works pretty much like the calculation of consumer surplus. We start with a supply and demand diagram. As you can see in the diagram above, the x-axis shows quantity while the y-axis shows price (in USD). *Hint: If you are not familiar with the concept of supply and demand at this point, please make sure to read our article on the law of supply and demand first.*

We will walk through the process with the help of a simple example. Let’s take the market for burgers. Before we can calculate a supply and demand diagram for this market, we need to know the supply and demand functions first. We will look at how to calculate them in different posts (how to calculate a demand function / how to calculate a supply function), for now, let’s just assume that the demand function is Q_{D} = -0.006x + 6 and the supply function is Q_{S}=0.006x. We use linear functions here (y = ax + b) for the sake of simplicity. However, please note that supply and demand functions do not necessarily have to be linear. With that being said, we can now use the two functions to draw our supply and demand curves.

Once we have our supply and demand diagram, we can find the market price. It is located at the intersection of the supply and the demand curve (i.e. the market equilibrium). That means, to calculate the market price we have to set the demand function equal to the supply function and solve for x. This gives us the equilibrium quantity. Then, all we need to do is plug the result back into the supply function and solve for Q_{S} to get the equilibrium price.

Using our example, the equilibrium quantity can be calculated as -0.006x + 6 = 0.006x. In this equation, x equals 500. That means, when the market is in equilibrium, a total of 500 burgers can be sold. Now, to find the market price, we need to plug this number back into the supply function (p = 0.006*500), which results in a market price of USD 3.00. Hence, when the market is in equilibrium, 500 burgers can be sold at a price of USD 3.00 each.

Once we have calculated the market price and quantity, we can add these numbers to the supply and demand diagram. As you can see, the market price is generally not the lowest possible price at which the good or service could be sold. This means, there are at least some sellers who would have been willing to sell the product at a lower price than the actual market price. These sellers can now earn a producer surplus, equal to the market price minus their individual willingness to sell. We can illustrate this by drawing a horizontal line between the y-axis and the market equilibrium (i.e. the intersection of S and D).

If we draw this horizontal line for our example, we see that it intersects the y-axis at a price of USD 3.00. As you can see in the illustration above, the line divides the area between the supply and the demand curve into two triangles. One triangle above the USD 3.00 line and another one below. The area of the lower triangle represents the sum of all individual producer surpluses, which equals total producer surplus.

To calculate the area of the lower triangle, we need to multiply its base with the height and divide the result by two (a = [b*h]/2). Please note that this formula only works with linear demand curves. Other types of demand curves require a more complex formula to calculate the area between two curves (see Wolfram|Alpha for more information).

If we apply this to our example, we can easily calculate the area of the lower triangle. We know that the base of the triangle is 500 and its height is 3.00. Thus, we can use the following equation: (500*3)/2 = 750.00. Thus, total producer surplus in our burger market is equal to USD 750.00.

Producer Surplus describes the difference between the amount of money at which sellers are willing and able to sell a good or service (i.e. willingness to sell) and the amount they actually end up receiving (i.e. the market price). Calculating producer surplus follows a 4-step process: (1) draw the supply and demand curves, (2) find the market price, (3) connect the price axis and the market price, and (4) calculate the area of the lower triangle.

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]]>The post Most Popular Posts of 2017 appeared first on Quickonomics.

]]>By the end of the year we had published a total of 108 posts across five categories: Infographics, Microeconomics, Macroeconomics, Basic Principles, and our Glossary. Like every year, we have analyzed all of them and created an overview of the most popular posts of 2017 by categories. So, without further ado, here’s the list.

We only published one infographic in 2017. It performed quite well on social media (facebook, twitter, and reddit), which is the main reason why it tops the list. The other two infographics in the top 3 have accumulated most of their views through organic search or referral traffic. We plan to publish more infographics again this year, thus it will be interesting to see how this section develops. But for now, these are the top 3 infographics of 2017:

1. 12 Things You Should Know About Economics – 2,958 views (published in 2017)

2. Overview of the German Economy 2016 – 2,113 views (94 in 2016)

3. Indian Economy at a Glance – 1,173 views (864 in 2016)

Like last year, the Microeconomics section has performed exceptionally well in 2017. The post “Positive Externalities vs Negative Externalities” still remains on top of the list. Meanwhile, it is worth noting that its views have more than tripled over the course of the year. All posts in this section got the majority of their views from organic search traffic. This is great news, especially considering that two out of the top 3 articles were only just published in 2017.

1. Positive Externalities vs. Negative Externalities – 44,434 views (12,527 in 2016)

2. How to Calculate Tax Incidence – 12,953 views (published in 2017)

3. Four Properties of Indifference Curves – 9,038 views (published in 2017)

The Macroeconomics section has also seen quite a few changes over the last few months. Last year’s winner (“Limitations of GDP as an Indicator of Welfare”) gotten more than twice as many views in 2017 than in the previous year. However, it still had to give way to the article “Calculating Consumer Price Index (CPI)”, which was published in March 2017. Check out the top 3 below:

1. Calculating Consumer Price Index (CPI) – 26,297 views (published in 2017)

2. Limitations of GDP as an Indicator of Welfare – 15,407 views (6,806 in 2015)

3. Government Policies to Reduce Poverty – 10,074 views (published in 2017)

The Basic Principles section has experienced an astounding amount of growth last year. Across all categories, the article “The Four Types of Market Structures” has accumulated the most views. By far. In addition to that, many of the Basic Principles posts that were only recently published in 2017 have performed exceptionally well. Let’s take a look at the top 3 below:

1. The Four Types of Market Structures – 121,065 views (703 in 2016)

2. The Four Types of Economic Systems – 43,783 views (published in 2017)

3. The Four Different Types of Money – 21,562 views (82 in 2016)

Like every year, the Glossary posts did not account for many views in 2017. This is not a surprise though, as their only purpose is to help our readers to understanding potentially difficult words from other posts. Below you can find the top 3 from this section:

1. Inflation – 59 views (11 in 2016)

2. Accounting Profit 17 views (12 in 2016)

3. Adverse Selection 15 views (9 views in 2015)

After an incredible year, we have counted a total of **426,348** views (43,100 in 2016) on **108** posts (84 in 2016) in 2017. Thank you once again for all the support and feedback. Stay tuned for more interesting and exciting content in 2018.

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]]>The post How to Calculate a Linear Demand Function appeared first on Quickonomics.

]]>The most basic form of a linear function is *y = mx + b*. In this equation, *m* represents the slope of the function, whereas *b* is the point where the line intersects the y-axis (i.e. the y-intersect). To give a simple example, let’s calculate a demand function for ice cream. In that case, we’ll call the basic demand function *D _{q}*, where

For the next step, we need some additional information. More specifically, we need to know the quantities demanded for at least two different prices. With this information we can create two ordered pairs in the form of *(x _{1},y_{1})* and

Now that we have the two ordered pairs, we can use them to calculate the slope of the demand function. The slope can be computed as the change in price divided by the change in quantity demanded between the two pairs. That means, we can use the following formula: m = (*y _{2 }–*

Next we can update the initial function to include the actual slope (instead of m). This allows us to calculate the y-intersect of the demand function by plugging in the values of one ordered pair and solving the resulting equation for b. In our example, that means we update our initial linear function to include the slope: *D _{q} = -0.005q + b*. Now we plug in the values of our first ordered pair (1000, 2.00), which results in the following equation: 2.00 = (-0.005*1000) + b. When we solve this for b, we find that the y-intersect is

If you want to make sure you calculated everything correctly, you can use the second ordered pair to double-check your demand function. To do this, simply plug the values into the demand function and see if the equation is still correct. For example, let’s use the values of our second ordered pair (800, 3.00) to validate the demand function *D _{q} = -0.005q + 7*. The resulting equation is 3.00 = (-0.005*800) + 7, which still holds true and thus validates our result.

For the sake of simplicity we often assume that demand functions are linear. This makes it easier to compute them, which in turn is important to analyze and understand many basic economic concepts. Calculating linear demand functions follows a simple four step process: (1) Write down the basic linear function, (2) find two ordered pairs of price and quantity, (3) calculate the slope of the demand function, and (4) calculate its y-intercept.

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]]>The post How to Calculate Consumer Surplus appeared first on Quickonomics.

]]>So how can we calculate consumer surplus, given its individual nature? Well, that’s actually not as complicated as it may sound. In fact, calculating consumer surplus follows a simple 4-step process: (1) draw the supply and demand curves, (2) find the market price, (3) connect the price axis and the market price, and (4) calculate the area of the upper triangle.

The easiest way to calculate consumer surplus is with the help of a supply and demand diagram. The diagram above has quantity on the x-axis and price (in USD) on the y-axis. Please note that it is critical to understand the relationship between supply and demand first in order to fully comprehend the concept of consumer surplus. So if you are not familiar with supply and demand yet, make sure to read our article on the law of supply and demand first.

Once again, we will use a simple example to walk through the process. Let’s look at an imaginary burger restaurant called Super Burger. If we want to draw the supply and demand diagram for this restaurant, we need to know the corresponding functions first. You can learn how to calculate linear demand functions in a different post. For now, let’s just say the demand function is Q_{D} = -0.006x + 6 and the supply function is Q_{S}=0.006x. Note that we are using linear functions (y = ax + b) for the sake of simplicity. However, be aware that not all supply and demand functions are linear. We can now use the two functions to draw the supply and demand curves.

Now that we have drawn the supply and demand curves, we can locate the market price (i.e. the equilibrium price). As we know (according to the law of supply and demand), the market price is located at the intersection of the supply and the demand curve (i.e. supply function = demand function). Thus, to calculate the market price we first need to solve this equation for the equilibrium quantity. Then we can find the corresponding price by plugging the result back into the supply (or demand) function.

In our example, the equilibrium quantity can be calculated as -0.006x + 6 = 0.006x. If we solve this equation for x, we find that x=500 burgers. That means, in the market equilibrium, Super Burger can sell 500 burgers to hungry customers. If we plug this back into the supply function (p = 0.006*500) we find that the market price is USD 3.00 per burger. In other words, Super Burger can sell a total of 500 burgers at a market price of USD 3.00 per burger.

Now that we have calculated the market price and quantity, we can take another look at the supply and demand diagram. As you can see, the market price is usually not the highest possible price at which the product could be sold. That means, there are usually at least consumers who would have been willing to buy the good or service at a higher price than the actual market price. These consumers now enjoy a consumer surplus of their individual willingness to pay minus the market price. To illustrate this, we can draw a horizontal line between the y-axis and the market equilibrium (i.e. the intersection of the supply (S) and demand curve (D)).

In our example, this line intersects the y-axis at USD 3.00. This creates two triangles, one above the USD 3.00 line and another one below the line. The area of the upper triangle represents the sum of all individual consumer surpluses, which is equal to total consumer surplus. We will look at how to calculate it in the next step.

To calculate the area of the upper triangle, we can multiply its base with the height and then divide the result by two (area = [b*h]/2). This holds true as long as the demand curve is linear. If that’s not the case we have to use a more complex formula to calculate the area under the curve (note: Wolfram|Alpha has a useful widget to help you with that).

Going back to our example, we can calculate the area of the upper triangle as follows: The base of the triangle is 500 and the height is 3.00. If we plug this into the formula we get (500*3)/2 = 750.00. That means, total consumer surplus is USD 750.00.

Consumer Surplus is defined as the difference between the amount of money consumers are willing and able to pay for a good or service (i.e. willingness to pay) and the amount they actually end up paying (i.e. the market price. To calculate consumer surplus we can follow a simple 4-step process: (1) draw the supply and demand curves, (2) find the market price, (3) connect the price axis and the market price, and (4) calculate the area of the upper triangle.

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]]>The post Differences between the GDP Deflator and CPI appeared first on Quickonomics.

]]>The GDP deflator measures the price level of all goods and services that are *produced within the economy (i.e. domestically).* Meanwhile, the Consumer Price Index measures the price level of all goods and services that are *bought by consumers within the economy*. That means, the GDP deflator does not include changes in the price of imported goods, while the CPI does not account for changes in the price of exported goods. In addition to that, the CPI represents a fraction of all domestically produced goods and services, because it exclusively focuses on consumer goods.

For example, let’s say the price of a Boeing 747 Jumbo Jet increases. Since Boeing is a US company, this shows up in the US GDP. As a result, the GDP deflator increases. However, a Boeing 747 is certainly not part of the market basket bought by typical US consumers. Therefore, the price increase will not affect the CPI. Thus, the increase in the price of a Boeing 747 has an effect on the GDP deflator but no effect on CPI.

To give another example, assume the price of a Toyota Corolla (i.e. one of the best-selling cars in the US) increases. This has no effect on US GDP, because Toyota is a Japanese company. However, typical consumers in the United States buy Toyota Corollas, so the car is part of the typical basket of goods used to calculate CPI. Hence, the increase in the price of a Toyota Corolla has an effect on CPI but not on the GDP deflator.

The CPI weighs prices against a *fixed basket *of goods and services, whereas the GDP deflator examines all *currently produced* goods and services. As a result, the goods used to calculate the GDP deflator change dynamically, whereas the market basket used for calculating CPI must be updated periodically. This can lead to diverging results if the prices of goods represented in both indicators don’t change proportionally. In other words, when the prices of some goods increase or decrease more than others, the two indicators may react differently.

For example, let’s look at the prices of Ford trucks. Ford is an American company that sells its cars and trucks within the United States and abroad. As a matter of fact, Ford ranks in the top 10 for biggest US export companies (by asset value) and cars sold within the US at the same time. As a result, changes in the price of a Ford truck show up in both the GDP deflator and CPI. Ford Trucks are produced in the US and also bought by typical US consumers. However, if Ford Trucks are weighed more heavily in the GDP deflator than in the CPI market basket, the price increase will have a higher impact on the GDP deflator. This will cause the two indicators to diverge.

To measure the increase in the overall price level in an economy, policy makers and economists usually monitor both the GDP deflator as well as the Consumer Price Index (CPI). Even though the two indicators usually show similar results, there are two important differences between the GDP Deflator and CPI that can cause them to diverge. First, they reflect a different set of prices and second, they weigh prices differently.

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]]>The post How to Calculate the GDP Deflator appeared first on Quickonomics.

]]>Nominal GDP is defined as the monetary value of all finished goods and services within an economy *valued at current prices* (see also Gross Domestic Product). So this part is pretty easy. All we have to do is multiply the quantity of all goods and services produced with their respective prices and add them all up.

To give an example, think of an economy that only produces ice cream and candy bars. The table below shows the quantity produced and prices of both goods for three consecutive years (2015, 2016, and 2017). If we calculate nominal GDP as described above, we find that for the year 2015 it amounts to USD 400,000 (100,000*2 + 200,000*1). Meanwhile for 2016 nominal GDP is USD 740,000 (120,000*2.5 + 220,000*2) and for 2017 nominal GDP amounts to USD 1,290,000 (150’000*4 + 230,000*3).

In a second step, we can now calculate real GDP. Unlike nominal GDP, real GDP shows the monetary value of all finished goods and services within an economy *valued at constant prices*. That means, we chose a base year and use the prices of that year to calculate the values of all goods and services for all the other years as well. This allows us to eliminate the effects of inflation.

In our example, we’ll pick 2015 as our base year. Thus, the reference prices of ice cream and candy bars are USD 2.00 and USD 1.00, respectively. Starting from there, we can now calculate real GDP for all three years. In 2015 real GDP amounts to USD 400,000 (100,000*2 + 200,000*1). Note that in the base year, real and nominal GDP are always the same because we use the same prices when calculating them. Meanwhile, for 2016 real GDP is USD 460’000 (120,000*2 + 220,000*1) and for 2017 it amounts to USD 530,000 (150,000*2 + 230,000*1). If you compare these numbers to the numbers we calculated above, you can already see that real GDP doesn’t grow quite as much as nominal GDP.

Now that we know both nominal and real GDP, we can compute the actual GDP deflator. To do this, we divide nominal GDP by real GDP and multiply the result with 100. This gives us the change in nominal GDP (from the base year) that cannot be attributed to changes in real GDP. Check out the formula below:

Going back to our example, we can quickly see that the GDP deflator for 2015 is 100 ([400,000/400,000]*100). The GDP deflator for the base year will always be 100, because nominal and real GDP have to be equal. However, things become more interesting when we look at the the following years. For the year 2016, the GDP deflator is7 160.9 ([740,000/460,000]*100). That means, from 2015 to 2016 the price level has increased by 60.9% (160.9 – 100). Similarly, the GDP deflator for 2017 is 243.4, which reflects a price level increase of 143.4% compared to the base year.

The GDP deflator is a measure of the price level of all domestically produced final goods and services in an economy. It is sometimes also referred to as the *GDP Price Deflator* or the *Implicit Price Deflator*. It can be calculated as the ratio of nominal GDP to real GDP times 100 ([nominal GDP/real GDP]*100). This formula shows changes in nominal GDP that cannot be attributed to changes in real GDP. Hence, the GDP deflator is often used by economists to measure inflation, together with the Consumer Price Index (CPI).

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]]>The post Nominal Interest Rates vs. Real Interest Rates appeared first on Quickonomics.

]]>The nominal interest rate describes the interest rate without any correction for the effects of inflation. Thus, the advertised or stated interest rates we see on bonds, loans or bank accounts is usually a nominal one. This rate shows you the actual price you are paid (or have to pay) if you lend (or borrow) money. Simply put, it shows you by how much the amount of money you have in your bank account increases over time.

To give an example, let’s assume you deposit USD 10’000 in your bank account. The account pays an annual interest rate of 3%. After one year your balance has increased to USD 10’300. That means, you have accumulated USD 300 in interest on your account. The annual interest rate of 3% in this example is the nominal interest rate. However, if you are familiar with the concept of inflation, you will know that this does not necessarily mean that you are in fact USD 300 “richer” now. As implied above, to see how much you can actually profit from a 3% nominal interest rate, we need to consider the effects of inflation. And that’s where the real interest rate comes into play.

The real interest rate refers to the interest rate adjusted to remove the effects of inflation. This rate shows you by how much the actual purchasing power of the money you have in your bank account increases over time. In other words, it describes the *real* yield of lending money or the *real* cost of borrowing money (hence the name). Calculating the real interest rate is actually quite simple. All we need to do is take the nominal interest rate and subtract the inflation rate. This equation is also referred to as the *Fisher equation*.

To illustrate this, let’s revisit our example. In one year, you accumulated USD 300 in interest with a nominal interest rate of 3%. Now, let’s say during the same period, the overall price level in the economy has increased by 1%. In this case, your money is worth less now than it was a year ago. Its buying power has decreased, because now you need more money to buy the same amount of goods. Therefore, to see how much you can actually profit from the additional USD 300, we need to adjust for the effects of inflation. In our example, that means we subtract 1% (inflation rate) from 3% (nominal interest rate), which results in a real interest rate of 2%. That means, your actual buying power has increased by 2%.

Interest rates help us evaluate and compare different investments or loans over time. In economics, we distinguish between two types of interest rates: the nominal interest rate and the real interest rate. On one hand, the nominal interest rate describes the interest rate without any correction for the effects of inflation. On the other hand, the real interest rate refers to the interest rate adjusted to remove the effects of inflation.

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