Nominal GDP is the monetary value of output produced in a country for a certain period (a year or quarter), measured at current prices. It contrasts with real GDP, which measures the same output but using constant prices, instead of current prices. Changes in nominal GDP occur due to changes in output, changes in prices of goods and services (inflation), or both.
Its value represents a country’s economic size. If you want to compare the size of the economy between countries, you need to use nominal GDP adjusted to purchasing power parity (PPP). That provides a more comparable picture because it eliminates the effects of exchange rate variations.
Another name for nominal GDP is GDP at current prices.
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 Indonesia’s output in 2018 is 100 units, and each price is at IDR50 per unit. Then, in 2019, the quantity of output does not increase, but the price rises to Rp60.
From the data, nominal GDP in 2018 is IDR 5,000 (100 units x IDR50) and in 2019 is IDR 6,000 (100 units x IDR 60).
What is the difference between nominal GDP and real GDP
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 2018 were the base year, then the real GDP values in 2018 would equal to 2019 since output remained constant. You use the price of Rp50 to calculate real GDP in both periods (i.e., Rp5.000 = 100 x Rp50).
Real GDP is 2019 lower than the nominal GDP of 2019. 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 in 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 2019. Of course, you have to use prices in 2019 instead of 2018. Using prices in the base year (2018) will only produce misrepresentation calculation.
Nominal GDP is also more representative if you want to compare the economic sector’s contribution to GDP. For example, you want to compare the share of the manufacturing vs. the agricultural to the GDP. Using nominal GDP will produce more accurate value.
Companies use it as a reference in setting the company’s revenue targets. Because using current prices, nominal GDP is better to measure the market value of their product and, therefore, their revenue potential.
But, if their’s target is output growth. Then, the real GDP is more appropriate for them to use references.
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 emerge. 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.
How to convert 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. You can calculate it by dividing the nominal GDP to real GDP.
GDP deflator = (Nominal GDP / real GDP) x 100
Take the example above:
Nominal GDP 2018: Rp 5,000; 2019: Rp6,000
Real GDP 2018: Rp5,000; 2019: Rp 5,000
- 2018 GDP deflator = (Rp. 5,000 / Rp. 5,000) x 100 = 100
- 2019 GDP deflator = (IDR 6,000 / IDR 5,000) x 100 = 120
The percentage change in the GDP deflator represents the inflation rate in the economy. 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 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 2018 and 2019 using the GDP deflator data:
- Real GDP 2018 = (IDR 5,000 x 100) / 100 = IDR5,000
- Real GDP 2019 = (IDR 6,000 x 100/120) = IDR 5,000
