Typically, when we think about the absolute GDP of an economy, we're dealing with nominal values.
However, when we consider GDP growth rates, it's typically real GDP that is used.
Let's have a look at the differences between nominal and real GDP.
Let's start with nominal GDP.
This is the total market value of all goods and services produced in an economy gauged using current prices without accounting for inflation.
It's like a snapshot that captures the economy size at present day price tags.
But here's the twist.
Nominal GDP is susceptible to price shifts.
Inflation can inflate it as higher prices lead to higher nominal GDP figures.
Conversely, deflation can deflate it as falling prices can cause nominal GDP to shrink even if the amount of goods and services turned out remains constant.
On the flip side, we have real GDP.
This is where things get real, quite literally.
Real GDP also tallies the total value of all goods and services and economy producers, but it does so by adjusting for inflation by anchoring prices to a base year.
Real GDP strips away the inflation impact allowing us to see the true volume of production.
It's the constant quantity that matters here, not the fluctuating price tags.
Real GDP moves only when there's a real change in output.
It's the go-to metric for comparing economic performance over time, crafting policies and sizing up economies on a global scale.
So when we talk about growth rates, we are looking through the lens of real GDP to grasp the economy's genuine expansion or contraction free from inflation's distortions.
When we measure real GDP, the choice of the base year is crucial.
It's a benchmark that sets the standard for comparison over time.
Think of the base year as a fiscal yardstick, one that's carefully selected from a period when the economy was relatively stable, free from extreme inflation or deflation, and not distorted by significant economic upheavals.
This base year provides a neutral backdrop against which we can measure real growth or decline in the economy, ensuring that the real GDP figures we discuss truly reflect changes in production volume rather than price fluctuations.
In this simple example, let's assume that year one is the base year.
In this year, 100 units were produced at a price of $5 giving nominal GDP of $500.
Since this is also the base year nominal GDP will be the same as real GDP In year two, more units are produced by this country 106 and prices have also increased to $5.50.
As such. Nominal GDP will be $583, a growth of 16.6% from year one.
However, this increase is not only driven by an increase in production or output, but also by the price increase.
To calculate the real GDP growth, we need to calculate the real GDP, which is essentially calculated as the current year's output at base year prices, which in this example would be 106 units at a price of $5 each, giving real GDP of $530.
This is an increase of 6% from year one, indicating an increase in economic activity as measured by output, independent of any changes in price.
Let's now turn our attention to a graphical representation that brings to life the distinction between nominal and real GDP.
What we have before us is a plot comparing the absolute figures of us nominal GDP against real GDP over time.
Our reference point or base year is set in 2017 a year whose economic conditions provide us with a stable comparison platform.
The timeline we are examining extends through a period of heightened inflation, a repercussion of the global COVID-19 pandemic.
Do you notice the widening gap between the two lines? This divergence underscores the significant impact of inflation during this era.
It visually narrates the story of how even when nominal GDP suggests growth, real GDP, which filters out inflation can tell us a very different tale about the economy's actual expansion.
