Understanding Real GDP and Nominal GDP

Introduction

Gross Domestic Product (GDP) is one of the most important indicators of a country's economic performance. It measures the total market value of all goods and services produced within a nation's borders during a specific period, typically a year or a quarter. However, GDP can be expressed in two different ways: nominal GDP and real GDP. Both are essential for understanding the economic health of a country, but they serve different purposes.

Nominal GDP is the raw economic output measured at current market prices, while real GDP adjusts for inflation, providing a more accurate reflection of an economy's true growth by removing the effects of price changes over time. This chapter will explore the differences between nominal GDP and real GDP, how to calculate them, and how to determine the GDP deflator, a tool used to measure inflation within an economy.

What is Nominal GDP?

Nominal GDP, also known as "current dollar GDP," is the total value of all final goods and services produced within a country in a given period, measured using the prices that are current in that period. In other words, nominal GDP is the raw economic output without adjusting for changes in price levels (inflation or deflation).

Key Characteristics of Nominal GDP:

• Current Market Prices: Nominal GDP is calculated using the prices that exist in the period being measured, reflecting both changes in production and price levels.

• Inflation Impact: Because it includes price changes, nominal GDP can be influenced by inflation. As prices rise, nominal GDP will increase even if the actual output of goods and services has not grown.

• Easy Calculation: Nominal GDP is often easier to calculate because it only requires data on production and the prices at which goods and services are sold in the current period.

The formula for nominal GDP is:

Consider a country that produces only one good, Good X.  If the country produces 1,000 units of Good X at $10 per unit, the nominal GDP would be $10,000. If the price of Good X rises to $12 per unit the following year but the quantity of Good X remains the same, the nominal GDP would increase to $12,000.  For this reason, nominal GDP is a misleading statistic for comparisons over time.  Nominal GDP can increase, even if the amount of goods and services produced, and therefore the standard of living, remains unchanged.

What is Real GDP?

Real GDP, also known as "constant dollar GDP," adjusts nominal GDP for changes in the price level. This is done to reflect the true value of goods and services produced in an economy by eliminating the effects of inflation or deflation. In essence, real GDP represents the actual growth in volume of production, not affected by price changes over time.

Key Characteristics of Real GDP:

• Adjusted for Inflation: Unlike nominal GDP, real GDP takes into account the effects of inflation, making it a more accurate reflection of economic growth.

• Constant Prices: To remove inflation, real GDP is calculated using prices from a base year, not current prices.

• True Economic Growth: By adjusting for price changes, real GDP gives a clearer picture of whether or not an economy is truly growing.

The formula for real GDP is:

Real GDP = Σ(Quantity of Goods and Services Produced x Constant Prices of Goods and Services)

Consider a country that produces only one good, Good X.  If the country produces 1,000 units of Good X at $10 per unit in the base year, the real GDP would be $10,000.  Now, assume that the country produces 2,000 units of Good X at $12 per unit during the following year.  In this case, the nominal GDP is $24,000 (because $24,000 = 2,000 x $12).  However, the real GDP, which utilizes prices from the base year, is $20,000 (because $20,000 = 2,000 x $10).  As you can see, the figure of $20,000 reflects the fact that the production of goods doubled.  The nominal GDP overstated the actual change in the standard of living because it included the effects of rising prices.

Why Do We Need Real GDP?

Nominal GDP can be misleading because it includes the effects of inflation. For example, if prices rise in an economy, nominal GDP might increase even if there has been no real increase in output. To get a better sense of whether an economy is genuinely growing, economists use real GDP. Real GDP allows for comparisons of economic performance across time by removing the inflationary effect.

Real GDP is important for several reasons:

• Accurate Growth Measurement: It provides a true picture of how much more (or less) a nation is producing over time, as it strips out the effects of price changes.

• Policy Decisions: Governments and central banks rely on real GDP to make informed decisions about economic policy, including fiscal and monetary measures.

The graph above shows the nominal GDP and real GDP of the United States since 2017.  As you can see from the graph, both nominal GDP and real GDP have increased.  However, part of the increase in nominal GDP was due to the effects of rising prices.  After factoring out the effects of inflation, the increase in real GDP, while still substantial, appears less dramatic.

What is the GDP Deflator?

The GDP Deflator is the ratio of nominal GDP to real GDP, showing how much prices have changed over time.  In other words, the GDP deflator is a price index that measures the level of prices of all new, domestically produced, final goods and services in an economy.

Key Characteristics of the GDP Deflator:

• Inflation Measure: The GDP deflator reflects the level of inflation in the economy.

• Comprehensive: Unlike other price indices like the Consumer Price Index (CPI), which only tracks prices of goods and services purchased by consumers, the GDP deflator includes the prices of all final goods and services produced in the economy.

The GDP deflator is calculated as follows:

Example:

If the nominal GDP of a country is $1 trillion and the real GDP is $800 billion, the GDP deflator would be:

As the GDP deflator is 125, this means that prices have risen by 25% since the base year.  (Remember, the base year value is always 100.)

How to Calculate Real GDP with the GDP Deflator

To calculate real GDP, you first need to rearrange the GDP Deflator Formula: 

Example:

Suppose in a given year, a country has:

• Nominal GDP = $500 billion

• GDP deflator = 120 (this means the price level has increased by 20% since the base year)

Real GDP would be calculated as:

Thus, the real GDP, adjusted for inflation, is $416.67 billion, reflecting the economy's true output in terms of constant prices.

Conclusion

In summary, nominal GDP and real GDP are two ways of measuring a country's total economic output, but they differ significantly in how they account for changes in prices. Nominal GDP is calculated using current prices, while real GDP adjusts for inflation, providing a more accurate measure of economic growth. The GDP deflator is a crucial tool in this process, helping to measure inflation by comparing the price level of goods and services in the current period to the base year. Understanding the distinction between nominal and real GDP, and how to calculate and interpret them, is vital for assessing an economy's true performance and making informed economic decisions.