1.4 Real and Nominal GDP
Video Transcript: (use scroll bar as required)
One of the things that is necessary when you're wanting to talk like an economist, is to understand some of the measurement that economists engage in, which appear in our finance programmes and our popular press almost every day.
One of the central organising concepts is called Gross Domestic Product - GDP and this is part of what's called the national accounts framework that the statisticians publish typically on a quarterly basis.
Now, what's GDP? It was defined as the final market value of all goods and services produced in an economy in some period. What does that mean? Well, here's an example. Let's take our economy and we've have three apples and two oranges.
What's that? That's our total production. Now, as you know, you can't compare apples to oranges. So the national statistician has a huge problem there because we need to express the apples and oranges in a common unit.
And so the way the statistician does that is to express the real output of the economy into currency figures, dollar terms, in our context. And so three apples might sell for a dollar per unit. So total sales of apples in the economy in this period, year 1 say, will be 3 dollars. And let's say that oranges sell at 50 cents each or then two oranges at 50 cents is 1 dollar. And if you add them together, the total sales in the economy for that year will be 4 dollars.
That's GDP. Simple.
Now, let's go to the second year. And we observed that prices have doubled. And so we've got 3 apples and 2 oranges. The apples are now selling at 2 dollars each and so 3 apples by 2 dollars is 6 dollars. And the oranges are now selling at 1 dollar, 2 oranges by 1 dollar each is 2 dollars. 6 dollars plus 2 dollars is 8 dollars. GDP has now gone from 4 dollars to 8 dollars.
And the question then you ask is, has the economy produced anything more? And of course, the answer is I've still got 3 apples and 2 oranges.
And so now you understand that while GDP is intended to be a measure of economic activity, we need to dig a bit further to understand the nuances of the measure, and here we come to the difference between nominal GDP, which is what I've just calculated, and real GDP, which is a measure of output that takes out the inflationary effects of price rises.
So now look at this example. We've got year 3 and we'll go back to the original year's prices. So apples are selling at 1 dollar and oranges are selling at 50 cents. So now we've got 6 apples selling at 1 dollar. So that's total sales of apples - 6 dollars. And we've got 4 oranges selling at 50 cents each. Total sales - 2 dollars. And now we've got GDP - 6 dollars plus 2 dollars equals 8 dollars.
Didn't we just have GDP last year at eight dollars? Yes, but this time we can answer the question, yes, the economy is producing more. It's grown in real terms. It's doubled its production and prices have remained stable.
And so that allows us to understand the concept of economic growth as measured by the statisticians and it allows us to understand that we need to take out the impact of price changes on the GDP measure to come up with a clean measure called real GDP, which is what we want, to assess growth.
And the next thing we need to understand is the concept of potential GDP.
End of Transcript
Study Notes:
Here's a little table to help sum up the example used in the video:
A Nominal GDP approach would look at the 'Total' column and conclude that GDP had doubled from the 1st year to the 2nd year, but remained the same for the 3rd year. A Real GDP approach would instead look at the fruit produced and identify that GDP was the same for years 1 and 2, and then doubled in the 3rd year. Nominal GDP measurements are at the mercy of price changes, whereas Real GDP focuses on actual output.
The System of National Income and Product Accounts (NIPA) is the framework assembled by national statisticians for measuring economic activity. The most important measure of production is Gross Domestic Product or GDP, which is the measure of all final goods and services evaluated at market prices which are produced per period of time, say a quarter or a year. GDP is a flow measure. We call this the nominal GDP measure because it relates to current prices.
Households buy final consumer goods and services; firms buy investment goods to increase capacity, and government buys goods and hires services. Intermediate goods and services are excluded to avoid double counting within the supply chain. For example, consider the transition from wheat to flour to bread. Only the final sale price of the bread is counted as GDP.
While GDP was designed to be a measure of output or economic activity rather than a measure of well-being, it is frequently used to indicate the latter, which makes it open to criticism. But, first, even as a measure of economic activity, there are weaknesses.
For example, if a family cleans its own home, the output is not counted as GDP but if the family hires a cleaner to do the same work, then it is counted. Many people argue that the GDP measure undercounts the contribution made to production by women because they perform a disproportionate amount of unpaid work. Many economists have called for reform of the accounting conventions to include more unpaid work in order to give greater recognition to the economic and social value of such so-called ‘women’s work’.
GDP also excludes the black market, grey market, and much of the production in the informal sector because of the difficulty of collecting the data. This is particularly a problem in developing nations where much of the food production does not reach formal markets. It is consumed by farmers and shared or sold in local markets without being subject to proper recording.
In terms of its use as a proxy indicator of well-being, a classic problem is that GDP ignores polluting activity when it measures, say, the output of a factory. The social, health and environmental costs are not deducted from the value of the output produced for the purposes of measuring GDP. However, if society had to hire workers and produce machinery in order to clean up the pollution coming from the producing factory, that would be counted toward GDP.
Another example is when we try to compare two nations that record the same GDP outcome, but one produces great volumes of military equipment, while the other produces a lot of healthcare and educational outputs. Using the GDP measure as a proxy for national progress might be quite misleading in this case.
Still another problem is inequality. It does not make any difference to the calculation of GDP whether almost all production goes to the top ten per cent of individuals or households, so that the bottom 90 per cent gets next to nothing, or vice versa. The GDP measure simply adds up national production without taking account of the distribution of the output. This can make GDP a bad measure for comparing living standards across countries.
There are alternative measures of economic well-being that attempt to get around these problems and you are encouraged to explore them further.
Finally, we need to understand that growth in GDP over time can be influenced by changes in market prices as well as output changes. If we find that GDP today is 100 times greater than it was a hundred years ago, does that mean that we enjoy 100 times more physical output? Clearly not if prices have also risen. Economists have devised ways of separating out the price change component of GDP increase from the actual output change. The techniques used by the statistician in this regard go beyond our focus here.
The important point to understand is that ‘real’ GDP corrects the nominal GDP measure for changes in prices. Thus, when we speak of economic growth, we are using the real GDP measure which has purged any price change impacts over time.
Also, as you will learn in the next segment, when we are estimating how much the economy can produce if all the productive resources are fully utilised, we are talking in real rather than nominal terms, even though the measure is expressed in currency units (such as, dollars).
