Nominal GDP Against Real GDP And Per Capital Real GDP

Nominal GDP vs Real GDP

Why do we have to do this distinction between nominal and real GDP? The answer is that real GDP is much more accurate metric in terms of measuring a country’s material wellbeing than that of nominal GDP (NGDP) because real GDP (RGDP) is adjusted for inflation or deflation.

In other words, real GDP refers to domestic production of final goods and services valued at constant prices whereas nominal GDP means domestic production of final goods and services valued at current prices.

Nominal GDP Example:

Imagine an economy that produces only two types of dates, Ajwa and Anbara dates, nothing else.

Let’s call this country Dateland. And assume that Dateland uses Saudi Riyal (SAR) as its currency. Dateland Statistical Agency (DSA) publishes the historical data for production and prices shown in Table 1:

Year	Price of Ajwa (per kilogram)	Quantity of Ajwa dates (In kilograms)	Price of Anbara (per kilogram)	Quantity of Anbara dates (In kilograms)
2019	8 SAR	900	3 SAR	3 SAR
2020	4 SAR	1,200	5 SAR	1,100
2021	6 SAR	1,000	5 SAR	1500

From the data in Table 1 we can easily calculate nominal GDP of Dateland at a given year by
multiplying the market price of each type of date with its quantity and then adding them together shown in Table 2:

Table 2

Year	Calculation	Nominal GDP
2019	8 SAR x 900 kg Ajwa dates + 3 SAR x 1,200 kg Anbara dates	= SAR 10,800
2020	4 SAR x 1,200 kg Ajwa dates + 5 SAR x 1,100 kg Anbara dates	= SAR 10,300
2021	6 SAR x 1,000 kg Ajwa dates + 5 SAR x 1,500 kg Anbara dates	= SAR 13,500

Real GDP

To calculate the real GDP, we need to choose a base year.

The base year should be a representative year in that the country in that year must not experience any abnormal occurrences such as famines, floods, devastating earthquakes, disruptive political upheavals, major economic downturns and so on – no calamity year is the base year.

Let’s assume that 2020 is one of those representative years in Dateland’s short economic history. Hence, we take 2020 as the base year for Dateland. Now using 2020 prices of Ajwa and Anbara dates, we can calculate real GDP of Dateland for the years 2019, 2020, and 2021 as shown in Table 3.

Year	Calculation	Real GDP
2019	4 SAR x 900 kg Ajwa dates + 5 SAR x 1,200 kg Anbara dates	SAR 9,600
2020	4 SAR x 1,200 kg Ajwa dates + 5 SAR x 1,100 kg Anbara dates	SAR 10,300
2021	4 SAR x 1,000 kg Ajwa dates + 5 SAR x 1,500 kg Anbara dates	SAR 11,500

It is not a surprise that in 2020, which is the base year, the nominal GDP of Dateland is equal to its real GDP.

Lesson learned – the base year’s real GDP is always equal to its nominal GDP. Furthermore, in nominal terms 2019 seems a better year than that of 2020 (NGDP of SAR 10,800 in 2019 versus NGDP of SAR 10,300 in 2020) but not in real terms (RGDP of SAR 9,600 in 2019 versus RGDP of SAR 10,300 in 2020).

A very high market price of Ajwa dates has inflated 2019 nominal GDP relative to 2020.

If we assume that people’s material wellbeing is the only factor that makes them happy (a very strong assumption!), then we can argue that in 2020 Dateland people were much happier than 2020 because the real GDP of the country in 2020 was higher than that of 2019.

However, among these three years, the happiest year for Dateland citizens was 2021 because in that year Dateland generated the highest real GDP (Table 3).

When economists talk about an economy’s GDP, most of the time, they mean real GDP instead of nominal GDP

However, we should still be very watchful about media’s use of the word GDP because usually it is impossible to distinguish whether the author means real or nominal GDP.

The information about a country’s material wellbeing is conveyed by real GDP not nominal GDP because real GDP is only about quantities whereas nominal GDP is about both quantities and prices.

GDP Deflator

One of the ways for capturing inflating (or deflating) effects of prices on GDP is to calculate GDP deflator for each year

using the following formula:

$G D P D e f l a t o r = \frac{N o m i n a l G D P}{R e a l G D P} \times 100$

GDP deflator is a metric of the average (or aggregate or general) price level calculated as the ratio of nominal GDP to real GDP multiplied by 100.

Let’s apply GDP deflator formula to find Dateland’s GDP deflator series for the period 2020-2022.

Year	Nominal GDP	Real GDP	GDP Deflator
2019	SAR 10,800	SAR 9,600	$\frac{10, 800 S A R}{9, 600 S A R} \times 100 = 112.5$
2020	SAR 10,300	SAR 10,300	$\frac{10, 300 S A R}{10, 300 S A R} \times 100 = 100$
2021	SAR 13,500	SAR 11,500	$\frac{13, 500 S A R}{13, 500 S A R} \times 100 = 117.4$

As we see from Table 4

Since nominal GDP and real GDP are equal in the base year, 2020!

01/03

the GDP deflator for the base year is always 100. This is another way to say that the base year’s real GDP is always equal to its nominal GDP.

Using the definition of GDP deflator, we can say that the average price levels, based on the GDP deflator, are 112.5 in 2019, 100 in 2020, and 117.4 in 2021.

02/03

Since GDP deflator measures the average price level, % change in GDP deflator reflects the % change of the average price level from one period to another.

If this percentage change is negative, we say the economy is experiencing a deflation, a decline in average price level.
if it is positive, an inflation, an increase in average price level.

It is important to reiterate that GDP deflator is a weighted average of the prices of all goods and services produced domestically in a given period, usually, in a year.

03/03

GDP deflator reacts to changes to prices not quantities.

This can be seen from the formula

If only quantities of goods and services increase but not prices, then both nominal GDP and real GDP increase at the same rate, making percentage change in GDP deflator 0 (zero), i.e., GDP deflator stays constant.
If, on the other hand, quantities of goods and services remain constant, but prices increase, then only nominal GDP increases pushing GDP deflator up at the same rate.

Measure of Inflation based on GDP Deflator:

Now it is time to calculate inflation measured by GDP deflator. Yes! There are many other ways to measure inflation such as Consumer Price Index (CPI), which we will mention when we talk about inflation in detail later.

Since here inflation is a percentage change of GDP deflator from one year to another, we will have inflation rates for years 2020 and 2021 not year 2019 because we do not have 2018 data. Table 5 shows how we calculate inflation rates based on GDP deflator for years 2020 and 2021.

However, you should keep in mind that inflation (or deflation) measured based on GDP deflator does not reflect correct inflation metric because GDP excludes goods and services imported by the country.

Table 5

Year	GDP Deflator	Inflation = % Change in GDP Deflator
2019	112.5
2020	100.0	$\frac{100 - 112.5}{112.5} \times 100 = 11.11 %$
2021	117.4	$\frac{117.4 - 100}{100} \times 100 = 17.40 %$

As shown by Table 5, in 2020, Dateland experienced a deflation of 11.11% (negative sign), whereas in 2021, the country went through an inflation of 17.40% (positive number). Table 6 provides us with a summary of Dateland’s economy in terms of rate of changes of nominal GDP, real GDP, and GDP deflator.

Table 6

Year	Rate of Change (%) of Nominal GDP	Rate of Change (%) of real GDP	Inflation=Rate of Change (%) of GDP Deflator
2020	$\frac{10, 300 S A R - 10, 800 S A R}{10, 800 S A R} \times 100 = 4.63 %$	$\frac{10, 300 - 9, 600 S A R}{9, 600 S A R} \times 100 = 7.29 %$	-11.11%
2021	$\frac{13, 500 S A R - 10, 300 S A R}{10, 300 S A R} \times 100 = 31.07 %$	$\frac{11, 500 S A R - 10, 300 S A R}{10, 300 S A R} \times 100 = 11.65 %$	17.40%

As seen from Table 6

Dateland’s economy in 2020 contracted in nominal terms (a decrease of 4.63%) but performed well in real terms (an increase of 7.29%).

In 2021, the country’s nominal GDP increased by 31.07% whereas its real GDP increased by 11.65%. 2020 was a deflationary year, whereas 2021 was an inflationary one.

However, we should know that a country might experience a deflation and a decline in real GDP simultaneously

Usually, economic expansions (increases in real GDP) come with inflation and economic contractions (decreases in real GDP) with deflation.

There are, we should also mention, episodes in which an economic contraction occurs simultaneously with inflation, which we call stagflation.

Real GDP Per Capita

Once again, economically meaningful information is conveyed by real variables such as real GDP, real interest rates, real exchange rate and so on, which we will be discussed later.

Thus, economic agents, from consumers to businesspeople to policymakers, make their decisions based on real variables not nominal variables, otherwise they end up making mistakes.

We have said that real GDP is a metric reflecting a country’s material wellbeing.

In 2021, our hypothetical economy Dateland achieved a real GDP of SAR 11,500.

The neighboring country say:

“Jujubeland, also using SAR as its currency, in the same year, was able to generate a real GDP of SAR 23,000.”

Can we conclude that Jujubeland was materially richer than that of Dateland in 2021?

Not immediately! We need another concept to make a meaningful comparison between Dateland and Jujubeland, which is per capita real GDP (or real GDP per person, if you do not like fancy words).

Let’s assume that Dateland has a population of 100 people whereas Jujubeland 1,000 people.

Applying real GDP per capita formula to these countries we have created Table 7 reporting 2021 per capita real GDP of them.

Table 7

Country	Real GDP 2021	Population 2021	Real GDP per Capita 2021
Dateland	SAR 11,500	100	$\frac{11, 500 S A R}{100} = 115 S A R$
Jujubeland	SAR 23,000	1000	$\frac{23, 000 S A R}{1, 000} = 23 S A R$

Using The Following Formula:

$R e a l G D P p e r c a p i t a = \frac{R e a l G D P}{p o p u l a t i o n} \times 100$

What we see in Table 7 is that even though Jujubeland had a higher real GDP in 2021 than that of Dateland, average Dateland person was materially richer than that of average Jujubeland person.

We keep repeating that real GDP, more precisely, real GDP per capita is a metric for material wellbeing for an average person. Remember, by definition, real GDP is real income of the people of the country under consideration. Unless the real income is distributed perfectly equally, for Dateland, an average real income of SAR 115 in 2021 does not mean that every Dateland citizen earned real income of SAR 115 in 2021.

Per capita real GDP is a metric for material wellbeing but not overall wellbeing. For example, if Jujubeland citizens, on average, had more leisure time in 2021 than those of Dateland citizens in the same year, then Jujubelanders were better off relative to Datelanders – but per capital real GDP does not take this happiness factor into account. Jujubelanders might have produced many goods and services that were not exchanged in markets such as growing their own vegetables andfruits for their own consumption. Real GDP does not take this into account.

Dateland might havebeen experiencing significantly more environmental degradation than that of Jujubeland. Real GDP does not take this into account. Income distribution might be much better in Jujubeland than that of Dateland. Real GDP per capita does not take this into account. There might be fewer criminal activities in Jujubeland than that of Dateland. Real GDP per capita does not take this into account.

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