Real GDP vs. nominal GDP: Which is a better indicator?

Real gross domestic product is often a more accurate reflection of the output of an economy than nominal GDP.

By eliminating the distortion caused by inflation or deflation or by fluctuations in currency rates, real GDP gives economists a clearer idea of how the total national output of a country is growing or contracting from year to year.

Real GDP

Gross domestic product is the total value of all of the goods and services produced by a nation in a given period, usually monthly, quarterly, and yearly.

The raw numbers include all consumer spending, government spending, investments, and exports. Total imports are deducted. When this number is tracked from year to year, it is seen as an important indicator of the economic health of the nation.

Real GDP is the value of a country's total output of goods and services adjusted for inflation or deflation.

It allows economists, policymakers, and analysts to assess the underlying growth of an economy without the distortion caused by changes in prices.

Real GDP is calculated by gathering data on the quantities of various goods and services produced in the economy (quantities are often called "real" quantities). Then, base-year prices are assigned to these quantities. The quantities produced are multiplied by their base-year prices, and the products are summed for all goods and services to get the real GDP for each year.

By comparing real GDP across different years, economists can determine whether the economy has grown or contracted in terms of actual output, abstracted from the effects of inflation. This information is crucial for making informed policy decisions, analyzing economic trends, and understanding the overall health of an economy.

Nominal GDP

Nominal GDP is also called "current dollar" GDP. It is the total in dollars (or any other currency) of goods and services consumed, plus government expenditures, investments, and exports, minus total imports.

The effects of inflation or deflation and the fluctuations of currency can convey a false picture of whether and how much an economy is growing or contracting over any given period of time.

Situations where real GDP is better

Comparing economic growth over time

When comparing economic performance across different time periods, real GDP is preferred because it accounts for changes in the general price level.

This allows for a more accurate assessment of whether an economy is actually growing or contracting in terms of the quantity of goods and services produced as different periods may have experienced different pricing growth (or contraction).

Evaluating long-term trends

 Real GDP is valuable for analyzing long-term economic trends and identifying patterns in an economy's output over the years.

It provides insights into the underlying growth trajectory of an economy, and, like the bullet above, it is most useful when standardizing the measurement across each period or year.

Comparing international operations

Real GDP is crucial when comparing economic performance between countries. Different countries might experience varying inflation rates, and using nominal GDP for comparisons could lead to misleading conclusions due to varying degrees of economic policy.

Formulating government policies

Real GDP is used by policymakers to assess the actual impact of economic policies over time. It helps them make informed decisions regarding fiscal and monetary policies by focusing on the real changes in economic output.

Analyzing investments

When evaluating investment opportunities, real GDP is crucial for understanding the potential returns on investments after accounting for inflation.

It provides a clearer picture of the investment's real growth potential not misaligned by inflated prices.

Note that investments may only be interested in particular subsets of data related to GDP as opposed to an entire country's economic output including that of products unrelated to the investment.

Situations where nominal GDP is better

Performing short-term analysis

For short-term assessments of economic performance, nominal GDP provides a snapshot of the current value of economic activity without the need for adjusting for inflation. This is especially relevant when looking at recent economic trends as inflation may matter in these cases.

Forecasting or calculating revenue

Governments use nominal GDP to calculate tax revenues, as many tax systems are based on a percentage of economic output. Since taxes are collected in current prices, nominal GDP is directly relevant to revenue calculations.

Analyzing Budgets

Organizations, governments, and businesses often set budgets based on expected revenues and expenditures in current prices. Though governments may be the primary user of GDP information, other entities may rely on this data to project and plan for future operations.

Boosting market sentiment

In some contexts, economic sentiment and market confidence can be influenced by the raw value of economic activity as presented by nominal GDP, especially in media and public discourse. During inflationary periods, nominal GDP will be higher than real GDP. Those looking to boost investor or economic morale may point to the higher figure should this better fit their agenda.

Calculating contractual agreements

Some contracts like debt agreements might use nominal GDP to determine payment terms or clauses related to economic performance. In this case, the holder or issuer may be contractually obligated to make calculations using nominal figures.

Example of real GDP vs. nominal GDP

The reason why real GDP is a superior method of expressing national economic performance can be easily illustrated.

Consider, for example, a hypothetical country that in the year 2010 had a nominal GDP of $100 billion, while by 2020 its nominal GDP was measured at $150 billion. Over the same period of time, inflation reduced the relative value of the local currency by 50%. Looking only at nominal GDP, the economy appears to have grown by 50% over the 10 years. But the real GDP expressed in 2010 dollars would be $75 billion, a substantial decline.

As a real example, let's compare the real GDP to nominal GDP of the United States from Q1 2023 to Q2 2023.13 The growth rate in each was:

Even though the economy may boast of growth in real GDP terms, a considerable amount of this growth was due to inflation and higher prices. By removing the effects of inflation, one can note that nominal GDP is negative, and economic activity strictly related to non-inflationary measurements did not increase quarter over quarter.

Source: Investopedia