Nominal and Real Values

When examining economic statistics, there is a crucial distinction worth emphasizing. The distinction is between nominal and real measurements, which refer to whether or not inflation has distorted a given statistic. Inflation refers to the increase in the overall price level over time.  Looking at economic statistics without considering inflation is like looking through a pair of binoculars and trying to guess how close something is: unless you know how strong the lenses are, you cannot guess the distance very accurately. Similarly, if you do not know the rate of inflation, it is difficult to figure out if a rise in GDP is due mainly to a rise in the overall level of prices or to a rise in quantities of goods produced. The nominal value of any economic statistic means the statistic is measured in terms of actual prices that exist at the time. The real value refers to the same statistic after it has been adjusted for inflation. Generally, it is the real value that is more important.

Real GDP

To determine whether the economy of a nation is growing or shrinking in size, economists use a measure of total output called real GDP. Real GDP, short for real gross domestic product, is the total value of all final goods and services produced during a particular year or period, adjusted to eliminate the effects of changes in prices.

If each final good or service produced, from hammers to haircuts, were valued at its current market price, and then we were to add the values of all such items produced, we would not know if the total had changed because output changed or because prices changed or both. The market value of all final goods and services produced can rise even if total output falls. To isolate the behavior of total output only, we must hold prices constant at some level. For example, if we measure the value of basketball output over time using a fixed price for valuing the basketballs, then only an increase in the number of basketballs produced could increase the value of the contribution made by basketballs to total output. By making such an adjustment for basketballs and all other goods and services, we obtain a value for real GDP. In contrast, nominal GDP, usually just referred to as gross domestic product (GDP), is the total value of final goods and services for a particular period valued in terms of prices for that period. Real GDP fell in the third quarter of 2008. But, because the price level in the United States was rising, nominal GDP rose 3.6%.

How to Calculate Real Gross Domestic Product

When keeping prices constant, you first have to decide which prices to use and choose a base year.  A base year is chosen by the government agencies who report economic data such as the Bureau of Economic Analysis in a fairly arbitrary fashion in the sense that any year could be a base year.  The base year will act as our reference point in time to which we compare other years. To compute Real GDP for any year, we will use the prices of goods and services from the base year.

We can also use a Price Index to adjust the Nominal GDP to obtain the Real GDP.  A price index is a way to track the change in the prices of goods and services in the economy. The Price Index associated with the Gross Domestic Product that measures the change in prices for all final goods and services is called GDP Deflator and is calculated as follow: GDP Deflator = (Nominal GDP / Real GDP) x 100

How to build a price index: Choose the prices that you want to track:  Food items, Consumer items, Manufactured goods…  This is what we call the ‘market basket.’  In this case, the market basket will be the GDP, all final goods and services. Choose a base year.  The price index will start at 100 at the base year. Compute the index: Price index (2016) = [ cost of the market basket (2016) / cost of market basket (base year) ] x 100

Click here for more details about price indexes:Index

The GDP Deflator can be used to adjust the nominal GDP to obtain the Real GDP: Real GDP = (Nominal GDP / GDP Deflator) x 100