Want to know how to find out whether the economy is growing? What are some metrics that show how well the economy is? Why do politicians like to avoid talking about real GDP instead of GDP? You will know how to answer all these questions once you read our Real vs. Nominal GDP explanation.
Difference between Nominal and Real GDP
To know if the economy is growing or not, we need to determine if the increase in GDP is due to a rise in output (goods and services produced) or an increase in prices (inflation).
This separates economic and financial measurements into two categories: Nominal and real.
Nominal means in current prices, such as the prices you pay whenever you make a purchase. Nominal GDP means that year's final goods and services are produced multiplied by their current retail prices. Everything that is being paid today, including interest on loans, is nominal.
Real means adjusted for inflation. Economists take the prices according to a set base year to adjust for inflation. A base year is usually a recent year in the past chosen to illustrate how much growth has occurred since then. The term "in 2017 dollars" means that 2017 is the base year and that the real value of something, such as GDP, is being shown - as if prices were the same as in 2017. This reveals whether or not output has improved since 2017.
If the actual value of the current year is greater than the base year, growth has occurred. If the actual value of the current year is smaller than the base year, it means that negative growth, or loss, has occurred. In terms of GDP, this would mean a recession (two or more consecutive quarters - three month periods - of negative real GDP growth).
Real and Nominal GDP definition
The bottom line is that the difference between nominal GDP and real GDP is that nominal GDP is not adjusted for inflation. You can see a rise in nominal GDP, but it could be simply because the prices are rising, not because more goods and services are produced. Politicians love talking about nominal GDP numbers, as it points to a 'healthier' picture of the economy instead of real GDP.
Nominal Gross domestic product (GDP) measures the dollar value of all final goods and services produced within a nation during a year.
Typically, GDP rises every year. However, this does not necessarily mean that more goods and services are being created! Prices tend to increase over time, and the general increase in the price level is called inflation.
Some inflation, around 2 percent per year, is normal and expected. Inflation above 5 percent or so may be considered excessive and harmful because it represents a substantial decrease in the purchasing power of money. Very high inflation is known as hyperinflation and signals a runaway excess of money in an economy that is causing prices to rise consistently.
Real GDP doesn't account for the price level and is a good metric to see how much growth a country experiences on an annual basis.
Real GDP is used to measure the growth in goods and services in the economy.
Examples of Real and Nominal GDP
When the news reports a nation’s economic growth and the size of its economy, it is usually doing so in nominal terms.
The nominal GDP of the United States was approximately $23 trillion in 20211. On the other hand, the real GDP in the U.S for 2021 was slightly below $ 20 trillion2. When looking at growth over time, it may be essential to use real GDP to make the numbers more manageable. By adjusting all annual GDP values to a fixed price level, graphs are more visually understandable, and correct growth rates can be determined. For example, the Federal Reserve uses 2012 as a base year to show proper real GDP growth from 1947 to 2021.
In the example above we see that the nominal GDP can be drastically different from the real GDP. If inflation isn't subtracted the GDP would appear 15% higher than it actually is, which is a very large margin of error. By finding the real GDP economists and policymakers can have better data on which to base their decisions.
The Formula for Real and Nominal GDP
The formula for nominal GDP is simply current output x current prices. Unless otherwise stated, other current values, such as income and wages, interest rates, and prices, are assumed to be nominal and have no equation.
The output represents the overall production that takes place in the economy, whereas prices refer to the prices of each good and service in the economy.
If a country were to produce 10 apples that sell for $2 and 15 oranges that sell for $3, then the nominal GDP of this country would be
Nominal GDP = 10 x 2 + 15 x 3 = $65.
However, we must adjust for inflation to find real values, which means removing them by either subtraction or division.
Knowing the inflation rate lets you determine the rate of real growth from nominal growth.
When it comes to the rate of change, the ability to find the real value is simple! For GDP, interest rates, and income growth rates, the real value can be found by subtracting the inflation rate from the nominal rate of change.
Nominal GDP growth - inflation rate = real GDP
If nominal GDP is growing by 8 percent and inflation is 5 percent, real GDP is growing by 3 percent.
Similarly, if the nominal rate of interest is 6 percent and inflation is 4 percent, the real rate of interest is 2 percent.
If the inflation rate is greater than the nominal growth rate, you lose value!
If nominal income increased by 4 percent annually and inflation was 6 percent annually, one's real income actually decreased by 2 percent or a -2% change!
The -2 value found using the equation represents a percent decrease. Therefore, one should be aware of the inflation rate when negotiating for wage increases to avoid losing real income in the real world.
However, to find the dollar value of real GDP, you must use the prices of a base year. Real GDP is calculated by using the prices of a base year and multiplying them by the total amount of goods and services produced during the year you want to measure its real GDP. The base year in this case is the first year of a GDP in a series of GDP years measured. You can think of the base year as an index that tracks changes in GDP. This is done to remove the impact that prices have on GDP.
Economists compare the GDP to the base year to see whether it has increased or decreased in percentage terms. This method allows you to track the base year's growth in goods and services. Usually, the year chosen as a base year is a year that didn't have extreme economic shock, and the economy was functioning normally. The base year is equal to 100. That's because, in that year, the prices and output in nominal GDP and real GDP are equal. However, as the base year prices are used to calculate real GDP, while output changes, there is a change in real GDP from the base year.
Another way to measure the Real GDP is using the GDP deflator as seen in the formula below.
The GDP deflator basically tracks the change in price level for all goods and services in the economy.
The Bureau of Economic Analysis provides the GDP deflator on a quarterly basis. It tracks inflation using a base year which is currently 2017. Dividing Nominal GDP by GDP deflator removes the effect of inflation.
Calculation of Real and Nominal GDP
To calculate the nominal and real GDP, let's consider a nation that produces a basket of goods.
It makes 4 billion hamburgers at $5 apiece, 10 billion pizzas at $6 apiece, and 10 billion tacos at $4 apiece. By multiplying the price and quantity of each good, we get $20 billion in hamburgers, $60 billion in pizzas, and $40 billion in tacos. Adding the three goods together reveals a nominal GDP of $120 billion.
This seems like an impressive number, but how does it compare to a previous year when prices were lower? If we have a previous (base) year's quantity and prices, we can simply multiply the base year's prices by the current year's quantities to get real GDP.
Nominal GDP = (current quantity of A x current price of A) + (current quantity of B x current price of B) +...
Real GDP = (current quantity of A x base price of A) + (current quantity of B x base price of B+)...
However, sometimes you do not know the base year's quantities of goods and must adjust for inflation only by using a provided change in prices! We can use the GDP deflator to find the real GDP. The GDP deflator is a calculation that determines the increase in prices without a change in quality.
As in the example above, assume the current nominal GDP is $120 billion.
It is now revealed that the current year GDP deflator is 120.
Dividing the current year GDP deflator of 120 by the base year deflator of 100 provides a decimal of 1.2.
Dividing the current nominal GDP of $120 billion by 1.2 reveals a real GDP of $100 billion.
The real GDP will be smaller than the nominal GDP due to inflation. By finding the real GDP, we can observe that the food examples above are quite heavily skewed by inflation. If inflation was not considered, 20 billion GDP would be misinterpreted as growth.
Graphical representation of Nominal and Real GDP
In macroeconomics, real GDP is revealed on many different graphs. It is often the value(Y1) shown by the X-axis (horizontal axis). The most common illustration of real GDP is the aggregate demand/aggregate supply model. It reveals that real GDP, sometimes labeled actual output or real domestic output, is found in aggregate demand and short-run aggregate supply intersection. On the other hand, the nominal GDP is found in the Aggregate demand curve as it represents the total consumption of goods and services in the economy, which is equal to the nominal GDP.
Fig. 1 - Nominal and Real GDP Graph
Figure 1 shows nominal and real GDP in a graph.
The main difference between the two is that the real GDP measures the overall production that takes place in the economy. On the other hand, nominal GDP consists of the production of goods and services and the prices in the economy.
In the short run, the period before prices and wages can adjust to changes; real GDP may be greater or less than its long-run equilibrium, which is shown by a vertical long-run aggregate supply curve. When real GDP is greater than its long-run equilibrium, often denoted by Y on the X-axis, the economy has a temporary inflationary gap.
Output is temporarily greater than average but will eventually return to equilibrium as higher prices become higher wages and force production to decrease. Conversely, when real GDP is lower than long-run equilibrium, the economy is in a temporary recessionary gap - commonly just called a recession. Lower prices and wages will eventually lead to more workers being hired, returning output to long-run equilibrium.
Nominal GDP vs Real GDP - Key takeaways
- Nominal GDP is representative of the current total output of a country. Real GDP subtracts inflation from that to determine how much growth in production actually occurred.
- Nominal GDP measures the total output X current prices. Real GDP measures total output by using a base year to measure the real change in production, this eliminates the effect of inflation in the calculation
- Real GDP is typically found using final goods and services and multiplying them by the prices from a base year, however, statistical agencies find this can lead to an overstatement, so they actually use other methods.
- Nominal GDP can be used to find real GDP by dividing it by the GDP deflator
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