What is Nominal Gross Domestic Product?

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Definition:

Nominal gross domestic product (GDP) is the total value of all goods and services that a country produces within its borders during a set period of time, without adjusting for the inflation (increase) or deflation (decrease) in the price of those goods and services.

🤔 Understanding nominal gross domestic product

Nominal gross domestic product (GDP) describes the strength of an economy, typically over the course of a quarter or year. The word nominal means that the statistic is reported using the current value of a given country’s currency – That is, no inflation adjustment has been made. In contrast, real GDP accounts for the effects of inflation (or sometimes deflation) in an economy. Both nominal and real GDP are otherwise the same – They add up all consumption, investment, government spending, and net exports in an economy to provide a snapshot of the country’s health. Countries with strong economies typically have high GDPs. When people talk about GDP, they’re usually referring to nominal GDP – If the word nominal or real does not appear before the figure, it is implied that it is nominal.

Example

Let’s take two examples – one theoretical and one real world.

Say a theoretical country, SchoolNation, only produces backpacks. It makes 50M bags in both 2019 and 2020. However, the backpack sells for $50 a pop in 2019 and $55 a pop in 2020. Nominal GDP for 2020 in this example is $2.75B ($55 per backpack 50M backpacks). But let’s say that 2019 is considered the base year, which is the year to which all other years are adjusted. In this case, the real GDP for 2020 is $2.5B ($50 per backpack 50M backpacks) – the same as 2019. This reflects that, while the price has increased due to inflation, the actual quantity of goods produced remains identical.

Now to the real world. US nominal GDP was $21.4T in 2019 and $20.6T in 2018, growing by about 4 percent year-over-year. When we look at real GDP, however, the actual growth rate decreases. By converting the nominal GDP of each year into 2012 (the base year) dollar values, real GDP was $19.1T in 2019 and $18.6T in 2018. After adjusting for inflation, the change in real GDP is only 2.3 percent.

Takeaway

Nominal gross domestic product (GDP) is like the amount on an hourly worker’s paycheck…

When an hourly worker gets paid, the number on their pay stub reflects the value of labor they produced during that pay period. When business is booming and they work more hours, their paycheck is bigger. If they got sent home early a lot because business was slow at the time, then their check is smaller. Much like nominal GDP reflects the amount of goods and services produced in a given period, their paycheck reflects how much work they did during the pay cycle. However, the amount on their paycheck – much like nominal GDP – doesn’t usually account for inflation.

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How do you calculate nominal GDP?

The US Bureau of Economic Analysis (BEA) keeps track of what’s going on in the country’s economy. It estimates nominal gross domestic product (GDP), along with many other national statistics each quarter to provide a snapshot of the economy’s health. Agencies like the World Bank and International Monetary Fund provide this data for many nations around the world.

Because nominal GDP is the value of all goods and services created inside a country's borders, the BEA and other agencies attempt to calculate the total output of their nations. In doing so, they inevitably have to adjust some numbers so that they don't double count goods. For example, they don’t want to count both the sale of lumber to a hardware store and that same lumber again when the hardware store sells it to a contractor.

Nominal GDP is calculated by adding up four primary categories: consumption, investment, government spending, and net exports (exports minus imports). The nominal GDP formula looks like this:

Nominal GDP = C + I + G + (X-M)

Let’s break these categories down a bit further.

C = Consumption

Consumption reflects the value of everything that households like yours purchase from businesses around the country. Everything from televisions to tacos are accounted for in the household consumption number. This is the largest of the categories that contribute to nominal GDP, comprising about 68% of US economic activity in 2018.

I = Investment

In this case, investment refers to the total amount of money that businesses spend on property, plants, and equipment (PP&E). Things like commercial real estate and large pieces of equipment are counted in this category.

Investment, however, doesn’t include the cost of goods sold (COGS) – aka how much a company spends to directly create a product or service. The reason that COGS isn’t included is because, otherwise, the value of goods used in the manufacturing process would be double counted. For example, imagine if we counted the sale of flour to a baker and also counted the full price of the bread they make. The price of the flour is included in the price of the bread, so the flour would get counted twice if we counted it in the baking process.

G = Government Spending

This figure tallies money spent by the government, mostly the wages it pays to employees. It doesn’t include spending that shows up in other variables in the nominal GDP equation, such as consumption (C). For example, government spending omits social security benefits paid to senior citizens. This is because that money gets counted as household consumption (C) when the recipients spend that check on items like groceries – again, nominal GDP ensures that it does not double count.

(X-M) = Net Exports

Since nominal GDP reflects the value created within a country’s borders only, the equation must adjust for the purchases that enter and leave the country. This is done by subtracting imports (M) from exports (X) to determine net exports. This result may be a negative number if the country imports more than it exports.

Exports (X) represent products made inside the country that get consumed outside of it. The value of these products must be captured. Conversely, imports (M) represent money leaving the country to purchase things made from outside of its borders. The value of these items must be subtracted, since they don’t contribute to a country’s GDP.

What is nominal GDP used for?

Nominal gross domestic product (GDP) is a popular macroeconomic statistic most heavily used by government officials and investors. It represents the current health and trajectory of the economy by assessing the current output of a country at current market prices. It’s the closest thing that a country has to market capitalization (the total value of a company). Instead of measuring the value of a country, GDP measures the value of its economic outputs (aka goods and services).

With this information, for example, the US Congress can decide how to shape the country’s fiscal policy, which is the use of spending and taxation to influence the economy. If nominal GDP is falling, the government may opt to intervene with tax cuts or rebates to stimulate growth. It may also elect to increase spending on major infrastructure like highways, which would create jobs and increase economic output (aka GDP).

The Federal Reserve – the central banking system of the US – also watches nominal GDP carefully. If the figure is falling during a quarter or year, the Federal Reserve may decide to decrease interest rates – This encourages borrowing and spending rather than saving. For example, if you can replace your refrigerator now without paying any interest, you might do that rather than saving up for a year before paying in cash. Lower interest rates decrease the cost of borrowing and encourage big purchases to happen sooner.

If economic growth is too fast, the Federal Reserve may worry about inflation (the increase in the price of goods and services over time). In this case, the Fed may opt to increase interest rates to slow things down and make borrowing less attractive. The Fed did this in 1980 to combat the rapid inflation of the 1970s.

The effort of the Federal Reserve to influence the level of economic activity is called monetary policy. Most countries have an agency that oversees monetary policy, such as the European Central Bank for the European Union and the Bank of Japan for Japan.

Ultimately, nominal GDP measures the amount of money that is flowing through the economy. Larger numbers suggest a healthier economy, more jobs, and a better quality of life for citizens. It also signifies the amount of value that can be taxed by the government. Therefore, many elected officials use nominal GDP as a gauge for what they can accomplish during their term in office.

Many investors compare nominal GDP to the national debt as an indicator of risk. The more national debt a country has as compared to its production (nominal GDP) in a given period, the more risky its economy appears. More risk implies the need for a greater rate of return on any debt the government issues. The nominal GDP growth rate is also an indication of how many goods and services companies are selling. The stock market often is an early indicator of what GDP may look like before the numbers are released.

How do you calculate nominal GDP growth rate?

Calculating the growth rate of nominal GDP is as simple as dividing one number by another to determine the percentage increase between two years.

Nominal GDP Growth Rate = (Later Period Nominal GDP / Earlier Period Nominal GDP) - 1

For example, maybe you want to know the growth rate of nominal GDP in the US between 2015 and 2016.

All you need to do is find those numbers from the Bureau of Economic Analysis (BEA), then divide them. The nominal GDP was $18.2T in 2015 and $18.7T in 2016. When you plug these numbers into the equation, you’ll get:

Nominal GDP Growth Rate = ($18.7T / $18.2T) - 1

Dividing $18.7T by $18.2T gives you 1.027.

Nominal GDP Growth Rate = (1.027) - 1

In other words, the nominal GDP in 2016 is 102.7 percent of what it was in 2015. That’s a growth rate of 2.7 percent.

Nominal GDP Growth Rate = 0.027 or 2.7%

What are the effects of inflation on nominal GDP?

Inflation is the general tendency for prices to rise over time, and is often referred to in the context of a specific country. There are several reasons that inflation happens, such as an expansion of money circulating in the economy, a rise in wages, or an increase in the general cost of doing business. But the outcome is always the same. It costs more money to buy the same exact things. Put another way, you can buy less stuff with the same amount of money – Inflation reduces your purchasing power. One dollar today doesn’t buy the same thing as $1 yesterday.

Since nominal GDP is basically a measure of how much money people, companies, and the government spend on goods and services, inflation increases the value of everything that goes into the nominal GDP calculation. Therefore, all else equal, nominal GDP rises at the rate of inflation. This phenomena means that nominal GDP often has a tendency to overstate the growth in GDP. Accounting for inflation using real GDP is important because inflation can cause nominal GDP to grow, even if there’s been no actual increase in economic output.

What is the difference between nominal GDP and real GDP?

Whenever economists use the term “real,” they mean that the distorting effects of inflation have been removed from the numbers. Removing this distortion allows you to compare two numbers without general price increases (inflation) muddying the picture.

You can think of this as what growth really has happened versus growth that just appears to have happened due to price increases.

Nominal just means that the numbers haven’t been adjusted for inflation (or sometimes deflation), as already discussed. These numbers are still in the same form as when they were collected – no manipulation of any sort has been done. Sometimes people call this the “current-dollar” or “money of the day” value because it reflects current market prices.

Imagine that nominal GDP increased by 2.5 percent from one year to the next. Elected officials may celebrate the fact that the economy is growing. However, what if the price of everything in the economy also increased by 2.5 percent? In that case, the exact same amount of production happened. There was no real growth in output and, therefore, no real growth in GDP.

Real GDP would expose this fact. It would show that, once you remove the distorting effects of inflation, the economy didn’t actually grow at all.

How do you convert nominal GDP to real GDP?

To convert nominal gross domestic product (GDP) to real GDP, you need to have some way to account for changes in the price level over time. The two most common methods are the GDP deflator and consumer price index (CPI).

The GDP deflator looks at what was actually purchased in a given time period. Then, the GDP deflator replaces the current market price for those goods with the prices in the past using a predetermined base year.

The CPI uses a slightly different approach, but generally comes out to a similar real GDP value. CPI uses a basket of goods approach to measure inflation. The general idea is to select a specific set of products, then watch how the prices of those goods change over time. From this sample of products, we can infer that everything else not included also underwent similar price increases. The Bureau of Labor Statistics (BLS) calculates the CPI for the US.

Either method results in an index value, which expresses how much prices differ in each year versus the predetermined base year. The base for the CPI is typically the average price in 1982-1984. However, any year can theoretically be used as the base year.

Once you have the index value of choice to account for inflation, calculating real GDP from nominal GDP is easy.

Calculating real GDP using CPI is as follows:

Real GDP of Earlier Year = (Later Year CPI / Earlier Year CPI) * Earlier Year Nominal GDP

Now let’s turn the 2016 nominal GDP into real GDP, expressed in 2019 dollars, using the CPI.

2016 Real GDP = (2019 CPI / 2016 CPI) * 2016 nominal GDP 2016 Real GDP = (255.657 / 240.008) * $18.7T = $19.9T

In other words, the real GDP in 2016 was $19.9T, using 2019 as the base year. The actual nominal GDP in 2019 was $21.4T. That means that the US economy saw real GDP growth of $1.5T, or around 7.5 percent, between 2016 and 2019.

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