Nominal GDP vs Real GDP

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.

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.

$NominalGDP=Output\times Prices$

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.

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 the inflation rate is greater than the nominal growth rate, you lose value!

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.

$RealGDP=\frac{NominalGDP}{GDPdeflator}$

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.

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.

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.