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Within GDP, there are two main ways to calculate it: nominal GDP and real GDP. This article focuses on understanding Nominal GDP, which reflects the monetary value of all goods and services produced in a country at current market prices. In simpler terms, it tells us the total value of everything produced within a country in a specific year, using the prices of that same year. Nominal GDP plays a crucial role in measuring a nation’s economic size and provides valuable insights beyond just economic growth. Let’s delve deeper and explore the world of Nominal GDP!
What is Nominal GDP?
Nominal GDP stands for Gross Domestic Product at current prices. It’s a measure of the total monetary value of all final goods and services produced within a country during a specific period (usually a year or quarter). Unlike real GDP, which uses constant prices, nominal GDP reflects the actual market prices of goods and services in that specific year. This means changes in nominal GDP can be due to two factors:
- Changes in output (quantity): If a country produces more goods and services, its nominal GDP will increase.
- Changes in prices (inflation): If the prices of goods and services rise due to inflation, nominal GDP will also increase, even if the actual output remains the same.
The value of a country’s nominal GDP serves as a key indicator of its economic size. It allows for a basic comparison of the total economic activity within different countries. However, it’s important to note that nominal GDP alone doesn’t account for differences in price levels between countries. To make a more accurate comparison, economists use nominal GDP adjusted to Purchasing Power Parity (PPP). This adjustment considers the relative cost of living in different countries, providing a more apples-to-apples comparison of economic size.
How to calculate nominal GDP
You can calculate the nominal GDP by multiplying output by price in the current year. Following is the formula:
- Nominal GDP = Output produced in year t x Price in year t
Let me use a simple example. The quantity of US output in 2022 is 100 units, and each price is $50 per unit. Then, in 2023, the quantity of output did not increase, but the price rose to $60.
The data show that the nominal GDP in 2022 was $5,000 (100 units x $50), and in 2023, it was $6,000 (100 units x $60).
Difference between nominal GDP and real GDP
When analyzing economic performance, understanding the difference between nominal GDP and real GDP is crucial. Both represent the total value of a country’s output, but they account for price changes in different ways. Nominal GDP uses current market prices, while real GDP uses constant prices (from a base year). This distinction allows real GDP to isolate changes in actual production (economic growth) from price fluctuations caused by inflation or deflation.
To measure real GDP, you use constant prices (base year prices). The formula for real GDP is as follows:
- Real GDP = Output produced in year t x Prices in the base year
In the previous example, if 2022 were the base year, then the real GDP values in 2022 would equal to 2023 since output remained constant. You use the price of $50 to calculate real GDP in both periods (i.e.,$5.000 = 100 x $50).
The real GDP of 2023 was lower than the nominal GDP of 2023. That’s because the nominal value depends not only on the price but also on the quantity of output.
So:
- Real GDP and nominal GDP will be equal in the base year.
- Nominal GDP will change if the quantity, price, or a combination of both changes.
- Changes in prices don’t affect real GDP. It will change only if the quantity changes.
- During inflation, nominal GDP will be higher than the real GDP. Conversely, ongoing deflation makes nominal GDP lower than real GDP.
Accordingly, real GDP is a more accurate indicator of economic growth than nominal GDP. By definition, economic growth measures the increase in economic activity, as indicated by the rise in production. And therefore, real GDP growth is a more appropriate metric for that.
Why does the nominal GDP still matter
Although it is not a more accurate measure of economic growth, it doesn’t mean nominal GDP is unimportant.
Nominal GDP is a more accurate metric for measuring the economic size and production value at a certain point in time. Say you want to calculate the market value of car production in 2023. Of course, you have to use prices in 2023 instead of 2022. Using prices in the base year (2022) will only produce a misrepresentation calculation.
Nominal GDP is also more representative if you want to compare the economic sector’s contribution to GDP. For example, you might want to compare the share of manufacturing vs. agricultural in the GDP. Using nominal GDP will produce a more accurate value.
Companies use it as a reference in setting their revenue targets. Current prices, nominal GDP, are better than current prices to measure the market value of their product and, therefore, their revenue potential.
But if their target is output growth, then the real GDP is more appropriate for them to use as a reference.
Economists use it to track the effect of the money supply on inflation. They observe a growth in the money supply relative to growth in nominal GDP.
If money growth is lower than nominal GDP growth, the disinflationary or deflationary pressure emerges. But, if money supply growth is faster than nominal GDP growth, there may be inflationary pressures.
In general, the nominal GDP is preferable when comparing GDP with other variables that do not adjust for inflation. The previous example is company revenue. Another example is debt. Debt is always expressed as a nominal number, so the ratio of debt to GDP is always based on nominal GDP.
Converting nominal GDP to Real GDP
To get real GDP, you need a third indicator, the GDP deflator. It measures the aggregate prices for goods and services produced in an economy and can be calculated by dividing the nominal GDP by the real GDP.
- GDP deflator = (Nominal GDP / real GDP) x 100
Take the example above:
Nominal GDP 2022: $5,000; 2023: $6,000
Real GDP 2022: $5,000; 2023: $5,000
- 2022 GDP deflator = ($5,000 / $5,000) x 100 = 100
- 2023 GDP deflator = ($6,000 / $5,000) x 100 = 120
The percentage change in the GDP deflator represents the economy’s inflation rate. It is an alternative to other price indicators, such as the Consumer Price Index (CPI) and the Producer Price Index (PPI). In this case, the inflation rate is 20% = [(120/100) -1] x 100. This percentage is equal to the increase in the price of goods: 20% = [(60/50) -1] x 100.
Then, to convert nominal GDP to real GDP, you need to convert the formula above to:
- Real GDP = (Nominal GDP x 100) / GDP deflator
Let’s convert the data in 2022 and 2023 using the GDP deflator data:
- Real GDP 2022 = ($5,000 x 100) / 100 = $5,000
- Real GDP 2023 = ($6,000 x 100/120) = $5,000
Beyond Nominal GDP: Considering Purchasing Power Parity (PPP)
While nominal GDP provides a snapshot of a country’s economic size, it doesn’t tell the whole story when comparing economies internationally. This is because nominal GDP uses current market prices within a country, which can be significantly affected by factors like inflation or currency exchange rates. Here’s where Purchasing Power Parity (PPP) comes in.
PPP is an economic concept that attempts to compare the buying power of a currency across different countries. It does this by creating a theoretical “basket of goods” that includes essential items like food, clothing, and housing. The idea is that this basket should cost roughly the same amount in different countries once adjusted for currency exchange rates.
Why PPP matters for international comparisons
Imagine comparing the nominal GDP of Country A with Country B. Country A might have a higher nominal GDP simply because prices are generally higher. However, if the PPP-adjusted GDP is calculated, it might reveal that Country B actually has a larger economy in terms of the amount of goods and services people can buy with their income.
PPP helps us make fairer comparisons by:
- Accounting for price level differences: It removes the distortion caused by inflation or currency exchange rates.
- Providing a more accurate picture of economic well-being: By comparing what people can actually purchase, PPP offers a better understanding of a country’s standard of living.
In essence, PPP allows us to look beyond nominal price tags and compare the true purchasing power of currencies across borders. This is crucial for making informed decisions about international trade, investments, and global economic trends.
