Final answer:
In an economy with falling price levels, changes in nominal GDP can both overstate or understate changes in real GDP, as it does not consider price level changes. Real GDP is a more reliable indicator of economic performance because it adjusts for inflation or deflation, thus truly reflecting the production volume.
Step-by-step explanation:
In an economy experiencing a persistently falling price level, changes in nominal GDP may either overstate or understate changes in real GDP. Nominal GDP represents the market value of all final goods and services produced in an economy, measured in current prices. However, this does not take into account changes in the price level over time. Therefore, when there is deflation (falling price levels), nominal GDP can understate the economic activity as the actual buying power may be increasing, even though nominal figures seem to suggest otherwise.
To better understand economic growth and real output, it is essential to adjust nominal GDP for changes in the price level, which yields the real GDP. This adjustment is done via the GDP deflator, which is a measure of the level of prices of all new, domestically produced, final goods and services in an economy. Real GDP provides a more accurate picture of the economy because it adjusts for inflation or deflation, reflecting only changes in the quantity of goods and services produced.
Utilizing figures such as those provided in Figure 19.8, we can see that a rising price level affects nominal GDP. For instance, the price level in 2010 was markedly higher than in 1960, meaning that the increase in nominal GDP was partly due to inflation rather than a real increase in output. This presents the importance of examining real GDP as it isolates the effect of price changes and focuses solely on the economic output.