Tag: Constant-price GDP

To make a sensible comparison of one year’s national income generated from the production of goods and services with another we need to take inflation into account. Changes in inflation-adjusted GDP represent changes in the volume of production of a country’s goods and services: in other words, the real value of goods and services. We revisit the blog written back in April 2019, prior the pandemic, to show how changes in real GDP evidence what we may refer to as the twin characteristics of economic growth: positive long-term growth but with fluctuating short-term rates of growth.

Real and nominal GDP

The nominal or current-price estimate for UK Gross Domestic Product in 2020 is £2.156 trillion. It is the value of output produced within the country in 2020. This was a fall of 4.4 per cent on the £2.255 trillion recorded in 2019. These values make no adjustment for inflation and therefore reflect the prices of output that were prevailing at the time.

Chart 1 shows current-price estimates of GDP from 1950 when the value of GDP was estimated at £12.7 billion. The increase to £2.156 trillion in 2020 amounts to a proportionate increase of almost 170 times, a figure that rises to 211 times if we compare the 1950 value with the latest IMF estimate for 2025 of £2.689 trillion. However, if we want to make a more meaningful comparison of the country’s national income by looking at the longer-term increase in the volume of production, we need to adjust for inflation. (Click here to download a PowerPoint copy of the chart.)

Long-term growth in real GDP

If we measure GDP at constant prices, we eliminate the effect of inflation. To construct a constant-price series for GDP a process known as chain-linking is used. This involves taking consecutive pairs of years, e.g. 2020 and 2021, and estimating what GDP would be in the most recent year (in this case, 2021) if the previous year’s prices (i.e. 2020) had continued to prevail. By calculating the percentage change from the previous year’s GDP value we have an estimate of the volume change. If this is repeated for other pairs of years, we have a series of percentage changes that capture the volume changes from year-to-year. Finally, a reference year is chosen and the percentage changes are applied backwards and forwards from the nominal GDP value for the reference year – the volume changes forwards and backwards from this point.

In effect, a real GDP series creates a quantity measure in monetary terms. Chart 1 shows GDP at constant 2019 prices (real GDP) alongside GDP at current prices (nominal GDP). Consider first the real GDP numbers for 1950 and 2020. GDP in 1950 at 2019 prices was £410.1 billion. This is higher than the current-price value because prices in 2019 (the reference year) were higher than those in 1950. Meanwhile, GDP in 2020 when measured at 2019 prices was £2.037 trillion. This constant-price value is smaller than the corresponding current-price value because prices in 2019 where lower than those in 2020.

Between 1950 and 2020 real GDP increased 5.0 times. If we extend the period to 2025, again using the latest IMF estimates, the increase is 5.9 times. Because we have removed the effect of inflation, the real growth figure is much lower than the nominal growth figure. Crucially, what we are left with is an indicator of the long-term growth in the volume of the economy’s output and hence an increase in national income that is backed up by an increase in production. Whereas nominal growth rates are affected both by changes in volumes and prices, real growth rates reflect only changes in volumes.

The upward trajectory observed in constant-price GDP is therefore evidence of positive longer-term growth. This is one of the twin characteristics of growth.

Short-term fluctuations in the growth of real GDP

The second characteristic is fluctuations in the rate of growth from period to period. We can see this second characteristic more clearly by plotting the percentage change in real GDP from year to year.

Chart 2 shows the annual rate of growth in real GDP each year since 1950. From it, we see the inherent instability that is a key characteristic of the macroeconomic environment. This instability is, of course, mirrored in the output path of real GDP in Chart 1, but the annual rates of growth show the instability more clearly. We can readily see the impact on national output of the global financial crisis and the global health emergency.

In 2009, constant-price GDP in the UK fell by 4.25 per cent. Then, in 2020, constant-price GDP and, hence, the volume of national output fell by 9.7 per cent, as compared to a 4.4 per cent fall in current-price GDP that we identified earlier. These global, ‘once-in-a-generation’ shocks are stark examples of the instability that characterises economies and which generate the ‘ups and downs’ in an economy’s output path, known more simply as ‘the business cycle’. (Click here to download a PowerPoint copy of the chart.)

Determinants of long-and short-term growth

The twin characteristics of growth can be seen simultaneously by combining the output path captured by the levels of real GDP with the annual rates of growth. This is shown in Chart 3. The longer-term growth seen in the economy’s output path is generally argued to be driven by the quantity and quality of the economy’s resources, and their effectiveness when combined in production. In other words, it is the supply-side that determines the trajectory of the output path over the longer term. (Click here to download a PowerPoint copy of the chart.)

However, the fluctuations we observe in short-term growth rates tend to reflect impulses that affect the ability and or willingness of producers to supply (supply-side shocks) and purchasers to consume (demand-side shocks). These impulses are then propagated and their effects, therefore, transmitted through the economy.

Effects of the pandemic

The pandemic is unusual in that the health intervention measures employed by governments around the world resulted in simultaneous negative aggregate demand and aggregate supply shocks. Economists were particularly concerned that the magnitude of these impulses and their propagation had the potential to generate scarring effects and hence negative hysteresis effects. The concern was that these would affect the level of real GDP in the medium-to-longer term and, hence, the vertical position of the output path, as well as the longer-term rate of growth and, hence, the steepness of the output path.

The extent of these scarring effects continues to be debated. The ability of businesses and workers to adapt their practices, the extraordinary fiscal and monetary measures that were undertaken in many countries, and the roll-out of vaccines programmes, especially in advanced economies, have helped to mitigate some of these effects. For example, the latest IMF forecasts for output in the USA in 2024 are over 2 per cent higher than those made back in October 2019.

Scarring effects are, however, thought to be an ongoing issue in the UK. The IMF is now expecting output in the UK to be nearly 3 per cent lower than it originally forecast back in October 2019. Therefore, whilst UK output is set to recover, scarring effects on the UK economy will mean that the output path traced out by real GDP will remain, at least in the medium term, vertically lower than was expected before the pandemic.

Data and Reports

Articles

Questions

  1. What do you understand by the term ‘macroeconomic environment’? What data could be used to describe the macroeconomic environment?
  2. When a country experiences positive rates of inflation, which is higher: nominal economic growth or real economic growth?
  3. Does an increase in nominal GDP mean a country’s production has increased? Explain your answer.
  4. Does a decrease in nominal GDP mean a country’s production has decreased? Explain your answer.
  5. Why does a change in the growth of real GDP allow us to focus on what has happened to the volume of production?
  6. What does the concept of the ‘business cycle’ have to do with real rates of economic growth?
  7. When would falls in real GDP be classified as a recession?
  8. Distinguish between the concepts of ‘short-term growth rates’ and ‘longer-term growth’.
  9. What do you understand by the term hysteresis? By what means can hysteresis effects be generated?
  10. Discuss the proposition that the pandemic could have a positive effect on longer-term growth rates because of the ways that people and business have had to adapt.

Just how large is the UK’s Gross Domestic Product and how quickly is it growing? Well, the latest Quarterly National Accounts from the Office for National Statistics show that the value of our economy’s output in Q3 2010 was £365.9 million. When measured across the latest four quarters, i.e. from the start of Q4 2009 to the end of Q3 2010, the total value of our economy’s output was £1.440 trillion. Across calendar year 2009 the UK’s GDP is estimated to have been £1.394 trillion.

When analysed in terms of the expenditure on the goods and services produced in the latest four quarters, household final consumption contributed £910.4 billion towards Gross Domestic Product. In other words, household expenditure over these four quarters was equivalent to 63% of GDP, exactly in line with its average since 1948. This only serves to demonstrate just how important the spending by households is for our short-term economic prospects.

Another important expenditure-component of GDP is gross capital formation. This is capital expenditure by the private and public sector and is estimated to have been £202.9 billion over the latest four quarters, equivalent to 14% of GDP. This is an important component because as well as affecting current levels of GDP, it also affects our economy’s potential output. This points to changes in capital expenditure having both a demand-side and a supply-side impact. Interestingly, the long-term average share for gross capital formation in GDP is around 18% and so about 4 percentage points higher than is currently the case.

So we now have a number which reflects the size of our economy: a little over £1.4 trillion. But, what about the rate at which the economy is growing? This time we have to be a little careful as to which GDP numbers we are using. The numbers we have so far considered have been measured at current prices and so at prevailing prices. When analysing the rate of economic growth, rather than analyse GDP at current prices, economists look at GDP at constant prices. By doing this we can immediately see whether the volume of output has increased. This is important because in the presence of price rises, an increase in the value of output could occur even if the volume of output remained unchanged or actually fell. For instance, in 1974 the volume of output or real GDP fell by 1.3%, but because the average price of our domestic output (known as the GDP deflator) rose by 14.8%, GDP measured at current prices rose by nearly 13½%.

The latest ONS figures show that real GDP grew by 0.7% in the third quarter 2010. For the record, GDP at current prices (nominal GDP) grew by 0.9%. The 0.7% increase in GDP in volume terms is down on the 1.1% figure for Q2. While this appears to constitute a reasonable rate of economic growth we can see from the articles below the concern amongst commentators that this third estimate of growth for Q3 had seen a downward revision from the previous estimates of 0.8%. Nonetheless, when compared with Q3 2009, the output of the UK economy in Q3 2010 is estimated to have grown by 2.7%. This is the strongest annual rate of economic growth since the third quarter of 2007.

Despite its relatively low historic share of GDP, gross capital formation was the most rapidly growing expenditure component in Q3, increasing by 5.2% over the quarter and by 16.6% over the latest four quarters. Household spending grew by 0.3% over the quarter and by 2% over the latest four quarters. Meanwhile, government final consumption, i.e. those government purchases not classified as capital expenditures, fell by 0.4% over the quarter and by 1.3% over the latest four quarters. Finally, the volume of exports rose by 1.5% over the quarter and by 7.5% over the latest four quarters, but the volume of imports increased more rapidly rising by 1.7% over the quarter and by 10.3% over the latest four quarters. This has contributed to a UK trade deficit from the start of Q4 2009 to the end of Q3 2010 of a little over £40.5 billion.

Articles

UK recovery weaker than first thought, official data shows Telegraph, Emma Rowley and Philip Aldrick (23/12/10)
Service sector output dips Financial Times, Chris Giles (23/12/10)
UK’s official economic growth estimates revised down Guardian, Graeme Wearden (22/12/10)
UK economic growth revised down BBC News (22/12/10)
Economic growth weaker than thought Press Association (22/12/10)
UK economic growth in 3rd quarter revised downward Bloomberg, Robert Barr (22/10/12)
Economic growth ‘is lower than we thought’ admits ONS Scotsman, Natalie Thomas (23/12/10)
UK GDP growth: analysts view of the revised data Telegraph (22/12/10)

Data

Latest on GDP growth Office for National Statistics (22/12/10)
Quarterly National Accounts, 3rd Quarter 2010 Office for National Statistics (22/12/10)
UK Economic Accounts, Time Series Data Office for National Statistics
For macroeconomic data for EU countries and other OECD countries, such as the USA, Canada, Japan, Australia and Korea, see:
AMECO online European Commission

Questions

  1. What do you understand by the terms nominal GDP and real GDP?
  2. Can you think of any other contexts in which we might wish to distinguish between nominal and real changes?
  3. The following are the estimates of GDP at constant 2006 prices:
    Q3 2009= £322.655bn, Q2 2010= £328.881bn, Q3 2010= £331.222bn
    Show how you would calculate both the quarterly rate of change and the annual rate of change for Q3 2010.
  4. What would happen to our estimates of the level of constant–price GDP in (3) if the base year for prices was 1986 rather than 2006? What would happen to the quarterly and annual growth rates you calculated? Explain your answer.
  5. Explain how gross capital formation could have both demand-side and supply-side effects on the economy? How significant do you think such supply-side effects can be?
  6. How important for short-term economic growth do you think household spending is? What factors do you think will be important in affecting household spending in the months ahead?