What Is Nominal Gross Domestic Product (GDP)?
The term nominal gross domestic product (GDP) refers to the GDP evaluated at current market prices. Put simply, nominal GDP is the total value of all goods and services produced in a given time period less the value of those made during the production process. GDP is the monetary value of all the goods and services produced in a country. Nominal GDP is one way to measure how well the economy is doing. It differs from real GDP in that the first one doesn't include the changes in prices due to inflation.
- A country's nominal gross domestic product assesses the economic production in its economy but includes the current prices of goods and services in its calculation.
- GDP is typically measured as the monetary value of goods and services produced.
- Since nominal GDP doesn't remove the pace of rising prices when comparing one period to another, it can inflate the growth figure.
- Growing nominal GDP from year to year may reflect a rise in prices as opposed to growth in the number of goods and services produced.
- Real GDP starts with nominal GDP but factors in price change between periods.
Nominal vs. Real GDP
Understanding Nominal Gross Domestic Product (GDP)
The economy is a series of interrelated processes that determine how resources are allocated. These processes include the production, distribution, and consumption of goods and services, along with other activities. These goods and services are required by those living within the economy.
There are many ways to determine and measure how well the economy is doing. Economists watch various economic indicators, such as unemployment, inflation, retail sales, industrial production, and gross domestic product. GDP is a metric that measures the health and well-being of a nation's economy. It's the total value of all goods and services that are produced during a certain period of time less the value of those that are employed during the production process.
There are different types of GDP, including real, actual, potential, and nominal. Nominal GDP is an assessment of economic production in an economy that includes current prices in its calculation. In other words, it doesn't strip out inflation or the pace of rising prices, which can inflate the growth figure. All goods and services counted in nominal GDP are valued at the prices that are actually sold that year.
How to Calculate Nominal GDP
Remember: Nominal GDP is the total value of goods and services produced within a specific economy. But just how is it measured? There are actually a couple of ways that you can use to calculate nominal GDP.
The first is the expenditure approach. In order to use this method, you'll have to know a few values, including:
- Consumer Spending (C)
- Business Investment (I)
- Government Spending (G)
- Total Net Exports (X-M): This figure is derived by subtracting import expenditures from the total value gained from a country's exports.
Once you have these figures, you can plug them into the following formula:
Nominal GDP = C + I + G + (X-M)
You can also use the GDP price deflator method to calculate nominal GDP. This approach involves the use of the following formula:
Nominal GDP = Real GDP x GDP Price Deflator
Economists use the prices of goods from a base year as a reference point when comparing GDP from one year to another. This price difference is called the GDP price deflator.
Effects of Inflation on Nominal GDP
Because it is measured in current prices, growing nominal GDP from year to year might reflect a rise in prices as opposed to growth in the number of goods and services produced. If all prices rise more or less together, known as inflation, then this will make nominal GDP appear greater. Inflation is a negative force for economic participants because it diminishes the purchasing power of income and savings, both for consumers and investors.
Inflation is most commonly measured using the Consumer Price Index (CPI) or the Producer Price Index (PPI). The CPI measures price changes from the buyer's perspective or how they impact the consumer. The PPI, on the other hand, measures the average change in selling prices that are paid to producers in the economy.
When the overall price level of the economy rises, consumers have to spend more to purchase the same amount of goods. If an individual’s income rises by 10% in a given period but inflation rises by 10% as well, then the individual’s real income (or purchasing power) is unchanged. The term real in real income merely reflects the income after inflation has been subtracted from the figure.
The U.S. is the world's largest economy, followed by China and Japan.
Limitations of Nominal GDP
There are several limitations to using nominal GDP as an economic indicator. There are several factors that aren't included in nominal GDP, such as:
- The total cost of production. While certain costs can be measured, nominal GDP doesn't include external costs that are important to the production process, such as waste and environmental factors.
- The production and sale of goods. When it comes to production, nominal GDP only takes final production into account rather than the steps and parts used during the manufacturing process. Similarly, this indicator also tracks inventory—not the actual sale of goods.
- Certain services. Nominal GDP doesn't include valuable services that contribute to society and the economy as a whole because they can't be quantified. These include unpaid internships and volunteer work.
Another limitation arises when an economy is mired in a recession or a period of negative GDP growth. Negative nominal GDP growth could be due to a decrease in prices, called deflation. If prices declined at a greater rate than production growth, nominal GDP might reflect an overall negative growth rate in the economy. A negative nominal GDP would be signaling a recession when, in reality, production growth was positive.
Nominal Gross Domestic Product (GDP) vs. Real Gross Domestic Product (GDP)
A nation's nominal GDP growth might overstate its growth if inflation is present when we compare GDP growth between two periods using the GDP price deflator. For example, if prices rose by 1% since the base year, the GDP deflator would be 1.01. Overall, real GDP is a better measure any time the comparison is over multiple years. That's why economists prefer to use real GDP over nominal GDP.
Real GDP starts with nominal GDP but it also factors in price changes from one period to another. Real GDP takes the total output for GDP and divides it by the GDP deflator. Let's say the current year's nominal GDP output was $2,000,000 while the GDP deflator showed a 1% increase in prices since the base year. Real GDP would be calculated as $2,000,000/1.01 or $1,980,198 for the year.
How Do I Calculate Nominal GDP?
Nominal GDP measures the economic production in an economy and includes the current prices of goods and services in its calculation. There are different ways to calculate nominal GDP:
- The expenditure approach accounts for the changes in quantity and the current market prices and it's a suitable way to measure nominal GDP.
- The GDP deflator approach uses the real GDP level and the change in price in its calculation. When multiplying both elements, the result is the nominal GDP.
Why Is Nominal GDP Higher Than Real GDP?
Nominal GDP is higher than real GDP because it takes current market prices into consideration. Conversely, real GDP is lower than nominal GDP because it takes market price changes into consideration.
What Is the Difference Between Nominal and Real GDP?
In short, nominal GDP measures the economic production at current market prices, whereas real GDP measures the economic production factoring in any prices changes in the market (deflation or inflation).
The Bottom Line
Nominal gross domestic product is a useful measure when GDP needs to be compared to any other factor that, like nominal GDP, is not inflation-adjusted. For example, a comparison of a nation's debt to its GDP will use nominal GDP. Keep in mind that debt is always measured in current dollars. Economists, however, favor real GDP is often over nominal GDP as it accounts for the effects of inflation.