1.1 Nominal vs Real GDP
Why do some countries have higher standards of living than others? This is a major question addressed by macroeconomics, one of the two subfields in economics. While microeconomics examines the decision making of individuals and firms and how they interact in markets, macroeconomics focuses on the economy as a whole and how it interacts with the rest of the world.
What is GDP?
A key measure of the standard of living in economics is the real gross domestic product per capita. The gross domestic product (GDP) is the market value of all final goods and services produced within a country during a specific period, typically a year. GDP is a measure of the size of a nation’s economy.
Measuring GDP involves finding the market value of each of the millions of goods and services that an economy produces, from bread and haircuts to computers and airplanes; GDP is then calculated by aggregating these market values into one total dollar value. In theory, the task appears straightforward – start by taking the quantity of each good or service produced, then multiply the quantity by the price at which it sold to find its dollar value. Then, add up these dollar values for all goods and services the economy produced in a given year to find the total market value or nominal GDP.
In reality, the complexity of modern economies renders the measurement and aggregation across different goods and services a very challenging task. Furthermore, while the output of material goods in an economy is relatively easy to compute, this is not so for services. For example, it is challenging to value the output of an insurance company or a bank.
Example 1: Nominal GDP and Welfare
Canada’s GDP was CAD 1.1 trillion in 2000 and CAD 2.2 trillion in 2020. Are we twice as well off in 2020 as we were 20 years before? Not necessarily. There are three possible reasons behind this increase:
- either the quantity of goods and services that we produce has increased or
- the prices have risen or
- a combination of these two.
If, for example, we produce the same quantity of goods and services in 2020 but their prices have doubled thus doubling GDP in 2020 compared to 2000, our standard of living would not have improved at all.
We are made better off only if the economy produces more goods and services in year 2020 compared to 2000.
A change in the nominal GDP reflects both changing quantities and changing prices. In economics, we rely on real variables, variables that adjust for changes in the price level over time, to make intertemporal comparisons. Nominal values are measured in terms of dollars while real values are measured in terms of quantities. In other words, real values account for the effect of inflation, the rate of increase in the average level of prices. Real GDP is a more appropriate measure of welfare than nominal GDP because a change in the real GDP unequivocally indicates a change in the quantities produced or the size of the economy.
While nominal GDP measures output in terms of current market prices, real GDP measures output in terms of constant prices, that is, it measures the value of production in a given year using the prices in a base year. To convert the nominal GDP in real terms, we need to “deflate” it by some measure of the aggregate price level such as the Consumer Price Index, which tracks movements in the average price level in an economy. The relationship between real and nominal GDP is as follows:
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(1) |
The Consumer Price Index (CPI) compares the cost of a fixed basket of goods and services bought by the “typical” household in a given period relative to the cost of that basket in a base period. The fixed basket used to compute Canada’s CPI contains thousands of goods and services, produced both domestically and imported from abroad, divided into 8 major categories: food; shelter; household operations, furnishings, and equipment; clothing and footwear; transportation; health and personal care; recreation, education and reading; and alcoholic beverages, tobacco products and recreational cannabis.
As the composition of the basket does not change over time, a rise in the cost of the basket reflects a rise in the average price level. The choice of base period is arbitrary – any year in our data can be designated as a base year. The CPI compares the cost of the basket in any other period to the cost of the basket in the base year. Conventionally, the value of the index is set equal to 100 in the base period to allow for easy comparisons between years. However, you must be mindful of that when converting nominal variables into real terms – see Examples 2 and 3.
Example 2: How Do We Interpret a Change in the CPI?
Canada’s CPI for 2020 was 112.6 with a base year of 2012. The implication is that prices increased by 12.6% between 2012 and 2020. Every $100 in 2012 has the same purchasing power as $112.6 in 2020. Alternatively, a dollar in 2012 has the same purchasing power as 112.6/100 = $1.126 in 2020. If, for example, your income was $20,000 in 2012, you would need 20,000 (112.6/100) = $22,520 in 2020 to have the same purchasing power as in 2012.
Example 3: Computing Real GDP
Table 1 below shows Canada’s nominal GDP and CPI for the period 2010 – 2020. Use the table to compute Canada’s real GDP.
Data Source: Statistics Canada
Have a look at the second column of Table 1. Notice the dramatic impact of the COVID-19 pandemic on the Canadian economy – in nominal terms, GDP in 2019 was higher compared to year 2020. Column 3 shows the steady rise in the aggregate price level over the period. To compute the annual inflation rate in Column 4, we find the percentage change in CPI between two consecutive years. Notice that the inflation rate varies in a very narrow range, between 0.71% and 2.28% during this 10-year period. This is expected as the Bank of Canada has targeted inflation since 1991. The Bank aims at keeping total CPI inflation at 2% – the midpoint of a target range of 1 to 3%.
To compute real GDP in Column 5 of Table 1, we first need to divide the CPI index by 100, which will enable us to compare the purchasing power of $1 in 2012, the base year, to any other year. For example, dividing the CPI in 2015 by 100 yields 104/100 = 1.04. Thus, $1 in 2012 has the same purchasing power as $1.04 in 2015. After that, we divide the real GDP by the CPI expressed as a decimal. The real GDP for any year in Column 5 is now deflated and expressed in 2012 dollars enabling us to make meaningful comparisons of the economy’s physical output over time. Notice also that the nominal and real GDP in the base year, 2012, are the same, which is always the case.
Drag and Drop Activity
Click and drag the numbers in the table below to assemble the correct equation for calculating Real GDP.
The study of the decision making of individuals and firms, and how they interact in markets.
The study of the economy as a whole and how it interacts with the rest of the world
A measure of economic output or the size of an economy. Calculated as market value of all final goods and services produced within a country during a specific period, typically a year.
GDP calculated using current market prices.
The rate of increase in the average level of prices.
Measures the value of goods and services produced by an economy during a specific period, adjusted for inflation.
Measures price changes over time by comparing the cost of a fixed basket of goods and services over time.
