Nominal Gross Domestic Product: Definition and Formula

What Is Nominal Gross Domestic Product (GDP)?

Nominal gross domestic product (GDP) is GDP evaluated at current market prices. It is the total value of all goods and services produced in a given time period less the value of those made during the production process.

Understanding Nominal GDP

The economy is a series of interrelated processes that determine how resources are allocated. These processes include the production, distribution, and consumption of goods and services, along with other activities. These goods and services are required by those living within the economy.

There are many ways to determine and measure how well the economy is doing. Economists watch various economic indicators, such as unemployment, inflation, retail sales, industrial production, and gross domestic product. GDP is a metric that measures the health and well-being of a nation's economy. It's the total value of all goods and services that are produced during a certain period of time less the value of those that are employed during the production process.

There are different types of GDP, including real, actual, potential, and nominal. Nominal GDP is an assessment of economic production in an economy that includes current prices in its calculation. In other words, it doesn't strip out inflation or the pace of rising prices, which can inflate the growth figure. All goods and services counted in nominal GDP are valued at the prices that are actually sold that year.

Nominal GDP Formula

Nominal GDP is the total value of goods and services produced within a specific economy. There are actually a couple of ways that you can use to calculate nominal GDP.

The first is the expenditure approach. In order to use this method, you'll have to know a few values, including:

• Consumer Spending (C)
• Business Investment (I)
• Government Spending (G)
• Total Net Exports (X-M): This figure is derived by subtracting import expenditures from the total value gained from a country's exports.

Once you have these figures, you can plug them into the following formula:

Nominal GDP = C + I + G + (X-M)

You can also use the GDP price deflator method to calculate nominal GDP. This approach involves the use of the following formula:

Nominal GDP = Real GDP x GDP Price Deflator

Economists use the prices of goods from a base year as a reference point when comparing GDP from one year to another. This price difference is called the GDP price deflator.

Components of Nominal GDP

Let's dive into the four main components of nominal GDP. First, consumption represents the total expenditure by households on goods and services. This includes everything from groceries and clothing to healthcare services and entertainment. It's the demand side of the economy, and consumer spending patterns can be influenced by things like disposable income and cultural trends.

Investment encompasses spending on capital goods, such as machinery, equipment, and infrastructure. When a country spends on investment, it has the aim of increasing future production capacity. Investment also includes expenditures on research and development.

Government spending refers to the expenditure by governments on goods and services. This can range from public education and healthcare to defense and infrastructure projects. While government spending contributes directly to nominal GDP, its impact on the economy can vary depending on the nature of the expenditure. For instance, investments in education and infrastructure can boost productivity, while excessive spending on subsidies or bureaucracy may actually lead to economic inefficiencies (if innovators no longer have incentives to innovate).

Last, the difference between a country's exports and imports is called net imports. When exports exceed imports, a country has a trade surplus. Conversely, when imports exceed exports, it has a trade deficit. Net exports reflect a country's competitiveness in international markets as how well a country may leverage global markets for expansion.

Effects of Inflation on Nominal GDP

Because it is measured in current prices, growing nominal GDP from year to year might reflect a rise in prices as opposed to growth in the number of goods and services produced. If all prices rise more or less together, known as inflation, then this will make nominal GDP appear greater. Inflation is a negative force for economic participants because it diminishes the purchasing power of income and savings, both for consumers and investors.

Inflation is most commonly measured using the Consumer Price Index (CPI) or the Producer Price Index (PPI). The CPI measures price changes from the buyer's perspective or how they impact the consumer. The PPI, on the other hand, measures the average change in selling prices that are paid to producers in the economy.

When the overall price level of the economy rises, consumers have to spend more to purchase the same amount of goods. If an individual’s income rises by 10% in a given period but inflation rises by 10% as well, then the individual’s real income (or purchasing power) is unchanged. The term real in real income merely reflects the income after inflation has been subtracted from the figure.

Usefulness of Nominal GDP

Nominal GDP is incredibly useful in economic analysis. It serves as a fundamental measure of economic growth, allowing policymakers, businesses, and investors to track changes in the size and direction of the economy over time.

Governments and central banks use nominal GDP data to formulate and evaluate economic policies. Policymakers theoretically make more informed decisions regarding fiscal and monetary measures by analyzing nominal GDP activity.

For example, nominal GDP per capita, which divides total GDP by the population, offers insights into the average income and purchasing power of individuals within a country. While it does not capture income distribution or disparities, it provides a broad measure of overall prosperity and living standards. A government can compare nominal GDP per capita over time to better understand if the average economic well-being of its citizens.

You can also use nominal GDP to compare economic performance across countries. It allows analysts to assess relative economic size, productivity levels, and competitiveness across countries. Analysts can then leverage other metrics driven by nominal GDP (like nominal GDP per capita) to compare trends and changes across countries over time.

Last, businesses can use nominal GDP data to inform strategic planning, market analysis, and investment decisions. Understanding broader economic trends enables companies to anticipate changes in consumer demand, adjust pricing strategies, and identify growth opportunities. For instance, companies like Omnicom Group have referenced nominal GDP as part of their Form 10-K annual filing.

Limitations of Nominal GDP

There are several limitations to using nominal GDP as an economic indicator. There are several factors that aren't included in nominal GDP, such as:

• The total cost of production. While certain costs can be measured, nominal GDP doesn't include external costs that are important to the production process, such as waste and environmental factors.
• The production and sale of goods. When it comes to production, nominal GDP only takes final production into account rather than the steps and parts used during the manufacturing process. Similarly, this indicator also tracks inventory—not the actual sale of goods.
• Certain services. Nominal GDP doesn't include valuable services that contribute to society and the economy as a whole because they can't be quantified. These include unpaid internships and volunteer work.

Another limitation arises when an economy is mired in a recession or a period of negative GDP growth. Negative nominal GDP growth could be due to a decrease in prices, called deflation. If prices declined at a greater rate than production growth, nominal GDP might reflect an overall negative growth rate in the economy. A negative nominal GDP would be signaling a recession when, in reality, production growth was positive. 

Nominal GDP vs. Real GDP

A nation's nominal GDP growth might overstate its growth if inflation is present when we compare GDP growth between two periods using the GDP price deflator. For example, if prices rose by 1% since the base year, the GDP deflator would be 1.01. Overall, real GDP is a better measure any time the comparison is over multiple years. That's why economists prefer to use real GDP over nominal GDP.

Real GDP starts with nominal GDP but it also factors in price changes from one period to another. Real GDP takes the total output for GDP and divides it by the GDP deflator. Let's say the current year's nominal GDP output was $2,000,000 while the GDP deflator showed a 1% increase in prices since the base year. Real GDP would be calculated as $2,000,000/1.01 or $1,980,198 for the year.

The Bottom Line

Nominal gross domestic product is a useful measure when GDP needs to be compared to any other factor that, like nominal GDP, is not inflation-adjusted. For example, a comparison of a nation's debt to its GDP will use nominal GDP. Keep in mind that debt is always measured in current dollars. Economists, however, favor real GDP is often over nominal GDP as it accounts for the effects of inflation.