Nominal GDP, How to Calculate It, When to Use It
Difference from Real GDP
Nominal gross domestic product is a measurement of economic output that doesn't adjust for inflation. GDP measures everything produced by all the people and companies within a country's borders. When you hear reports of a country’s GDP that don’t specify the type, it's likely to be nominal GDP.
When the BEA reports quarterly GDP, it presents it as an annualized rate. This tells you that the economy would produce that amount for the year if it kept going at the same rate. Each month, the agency revises the quarterly estimate as it receives updated data.
What Nominal GDP Measures
Nominal GDP includes goods and services. When measuring goods, it only counts final production. The BEA does not count the parts manufactured to make the product. For example, it counts a truck once it's manufactured. It doesn't count parts such as tires, axles, or seats.
Nominal GDP does not include sales. For example, the BEA counts a new car when it's shipped to the dealer. The BEA records it as an addition to inventory, which increases GDP. When the dealer sells it, then the BEA records it as a subtraction to inventory. That reduces GDP until the factory builds another car to replace it.
Services is a critical component of GDP. Examples include haircuts, financial advice, and babysitting. But the BEA doesn't count some services that are too difficult for it to measure. These include unpaid child care, elder care, or housework. It doesn't measure volunteer work for charities. The BEA doesn't include paid work that's illegal, also called the shadow or black economy.
Nominal GDP does not include the full cost of production. It neglects the external costs like air and water pollution, nuclear waste, and deforestation. These costs are created by production but are borne by society at large. The only way to include those costs is through a Pigouvian tax such as a carbon tax.
How to Calculate Nominal GDP
The formula for nominal GDP is:
These are also the components of GDP. They tell you how much each industry contributes to the economy.
Nominal Versus Real GDP
The U.S. Bureau of Economic Analysis reports both real and nominal GDP. It calculates real U.S. GDP as an annual rate from a designated base year. You can see the difference between real and nominal GDP when you look at them by year.
You must use nominal GDP when your other variables don't exclude for inflation. For example, if you are comparing debt to GDP, you've got to use nominal GDP since a country's debt is also nominal. The U.S. debt to nominal GDP remained below 100 percent until 2014. Since then, the debt ratio has increased each year.
When You Should Use Real GDP Instead
You must use real GDP when you are comparing the economic output from one year to the next, or between countries.
Real GDP tells you if the economy is growing faster than the quarter or year before. This reveals where the economy is in the business cycle. Declining GDP growth rates signal a contraction. If the current GDP is negative, the economy is in a recession. The ideal GDP growth rate is between 2 to 3 percent.
The Federal Reserve reviews the GDP growth rate before it changes the fed funds rate. It will raise the rate when growth is too fast. When that happens, consider a fixed-rate mortgage to lock in low-interest rates.
The Fed lowers rates when growth is below the ideal rate. That's when you should opt for an adjustable-rate mortgage. It will allow you to benefit from future lower rates. Investors also use the GDP growth rate to decide how to adjust the asset allocation in their portfolios.
You must use real GDP to compare GDP by country. But, to compensate for the different cost of living between countries, you must also use purchasing power parity. Countries with good growth rates attract more investors for stocks, bonds, and sovereign debt.