The distinction between nominal and real values is an incredibly important one in economics. We apply the latest GDP numbers from the ONS to show how the inflation-adjusted numbers help to convey the twin characteristics of growth: positive longer-term growth but variable short-term rates of growth. It is real GDP numbers that help us to understand better the macroeconomic environment and, not least, its inherent volatility. To use nominal GDP numbers means painting a less than clear, if not inaccurate, picture of the macroeconomic environment.
The provisional estimate for GDP (the value of output) in the UK in 2018 is £2.115 trillion, up 3.2 per cent from £2.050 trillion in 2017. These are the actual numbers, or what are referred to as nominal values. They make no adjustment for inflation and reflect the prices of output that were prevailing at the time. Hence, the figures are also referred to as GDP at current prices.
The use of nominal GDP data can be something of a problem when we compare historical values. In 1950, for example, as we can see from Chart 1, nominal GDP in 1950 was a mere £12.926 billion. In other words, the nominal figures show that the value of the country’s output was 163.595 times greater in 2018 (or an increase of 162,595 per cent). However, if we want to make a more meaningful comparison of the country’s national income we need to adjust for inflation. (Click here to download a PowerPoint copy of the chart.)
If we measure GDP at constant prices we eliminate the effect of inflation. This allow us to make a more meaningful comparison of national income. Consider first the real GDP numbers for 1950 and 2018. GDP in 1950 at 2016 prices was £373.9 billion. This is higher than the nominal (current-price) value because prices in 2016 were higher than those in 1950. Meanwhile, GDP in 2018 when measured at 2016 prices was £2.034 trillion. This real value is smaller than the corresponding nominal value because prices in 2016 where lower than those in 2018.
Between 1950 and 2018 there was a proportionate increase in real GDP of 5.439 (or a 443.9 per cent increase). 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 growth in the volume of output. Whereas nominal growth rates are affected both by changes in volumes and prices, real growth rates reflect only changes in volumes.
Consider now output growth between 2017 and 2018. As we saw earlier, the nominal figures suggest growth of 3.2 per cent. In fact, GDP at constant 2016 prices increased from £2005.4 trillion in 2017 to £2,033.6 trillion in 2018: an increase of 1.4 per cent. This was the lowest rate of growth in national output since 2012 when output also grew by 1.4 per cent. In 2017 national output had increased by 1.8 per cent, the same increase as in 2016.
To put the recent growth in national output into context, Chart 2 shows the annual rate of growth in real GDP each year since 1950. Across the period, the average annual rate of growth in real GDP and, hence, in the volume of national output was 2.5 per cent. In the current decade growth has averaged only 1.9 per cent. This followed falls of 0.3 per cent and 4.2 per cent in 2008 and 2009 respectively as the effects of the financial crisis on the economy were felt. (Click here to download a PowerPoint copy of the chart.)
By plotting the percentage changes in real GDP from year to year, we get a much clearer sense of the inherent instability that we identified at the outset as a characteristic of growth. This is true not only for the UK, but economies more generally. This instability is the key characteristic of the macroeconomic environment. It influences and informs much of what we study in economics.
The variability of growth rates that create the instability of economies again requires an understanding of the distinction between nominal and real GDP. Chart 3 illustrates the growth in GDP both in nominal and real terms. The average annual rate of growth of nominal GDP is 7.8 per cent, considerably higher than the average real growth rate of 2.5 per cent per year. The difference again reflects the effect of rising prices. (Click here to download a PowerPoint copy of the chart.
Chart 3 clearly shows the wrong conclusions that can be drawn if one was to focus on the growth in nominal GDP from year to year. Perhaps the best example is 1975. In this year nominal GDP grew by 24.2 per cent. However, the volume of national output contracted: real GDP fell by 1.5 per cent. The growth in nominal GDP reflects the rapid growth in prices seen in that year. The economy’s average price level (the GDP deflator) rose by 26.1 per cent. Hence, the growth in nominal GDP reflected not an increase in the volume of output – that fell – but instead a large increase in prices.
The importance of the distinction between nominal and real GDP is further demonstrated by the fact that since 1950 nominal GDP has fallen in only one year. In 2009 nominal GDP fell by 2.7 per cent. The 1.6 per cent rise in the economy’s average price level was not enough to offset the fall in the volume of output of just over 4.2 per cent. In other years when the volume of output (real GDP) fell, the effect of rising prices meant that the value of output (nominal GDP) nonetheless rose.
So to conclude, the distinction between nominal and real GDP is crucial when analysing economic growth. To understand the distinction gives you a truly real advantage in making sense of the macroeconomic environment.
- What do you understand by the term ‘macroeconomic environment’? What data could be used to describe the macroeconomic environment?
- When a country experiences positive rates of inflation, which is higher: nominal economic growth or real economic growth?
- Does an increase in nominal GDP mean a country’s production has increased? Explain your answer.
- Does a decrease in nominal GDP mean a country’s production has decreased? Explain your answer.
- Why does a change in the growth of real GDP allow us to focus on what has happened to the volume of production?
- What does the concept of the ‘business cycle’ have to do with real rates of economic growth?
- When would falls in real GDP be classified as a recession?
- Distinguish between the concepts of ‘short-term growth rates’ and ‘longer-term growth’.
- Why might the distinction between nominal and real be important when analysing changes in people’s pay? What would be the significance of an increase in real pay?
Economic growth is vital to an economy: it helps to create jobs and is crucial in stimulating confidence, both for businesses and consumers. Growth comes from various sources, both domestic and external, and so for each individual country it’s not just its growth rate that is important, but the growth rates of other countries, in particular those it trades with.
Recent data suggest that the global economy could be on the downturn and here we consider three countries/continents.
The US economy has been doing relatively well and we saw discussion by the Federal Reserve as to whether the economy was in a position to be able to handle an increase in interest rates. Although rates didn’t rise, there was a general consensus that a rate rise would not significantly harm the economy. However, perhaps those opinions may now be changing with the latest information regarding US growth. In the second quarter of 2015, growth was recorded at 3.9%, but according to the Department of Commerce, it fell to 1.5% for the third quarter. Though it’s still a solid growth rate, especially compared to other economies, it does represent a significant fall from quarter to quarter.
Many analysts suggest that this slowing is just a blip, partly the result of running down stocks, but it’s also a trend that has occurred in the UK. Although the fall in growth in the UK (see series IHYR) has been less than in the USA, it is still a fall. Annual growth was recorded at 2.7% in quarter 1, but fell to 2.4% in quarter 2 and to 2.3% in quarter 3 (with GDP in quarter 3 only 0.5% higher than in quarter 2). A big cause of this slowdown in growth has been a fall in manufacturing output and it is the service sector that prevented an even larger slowdown.
And it’s not just the West that is experiencing declining growth. The IMF has warned of a slowdown in economic growth in Africa. Although the absolute annual rate of growth at 3.75% is high compared to the UK, it does represent the slowest rate of growth in the past six years. One key factor has been the lower oil prices. Although this has helped to stimulate consumer spending in many countries, it has hit oil-producing countries.
With some of the big players experiencing slowdowns, world economic growth may be taking something of a dive. The Christmas period in many countries is when companies will make significant contributions to their annual sales, and this year these sales are going to be vital. The following articles consider the slowdowns in growth around the world.
US growth slows despite spending free Financial Times, Sam Fleming and Richard Blackden (29/10/15)
US economic growth slows in third quarter as businesses cut back The Guardian, Dominic Rushe (30/10/15)
US economic growth slows sharply BBC News (29/10/15)
US Q3 gross domestic product up 1.5% vs 1.6% growth expected CNBC, Reuters (29/10/15)
US growth cools in third quarter Wall Street Journal, Eric Morath (29/10/15)
UK economic growth slows to 0.5% in third quarter BBC News (27/10/15)
GDP growth in the UK slows more than expected to 0.5% The Guardian, Julia Kollewe (27/1015)
UK growth slows as construction and manufacturing output shrinks The Telegraph, Szu Ping Chan (27/10/15)
UK economy loses steam as GDP growth slows to 0.5% Financial Times, Ferdinando Giugliano (27/10/15)
No UK growth without services BBC News, Robert Peston (27/10/15)
IMF warns of African economic slowdown BBC News (27/10/15)
African growth feels the strain from China’s slowdown Financial Times, Andrew England (27/10/15)
Tax credits: George Osborne ‘comfortable’ with ‘judgement call’ BBC News (22/10/15)
IMF revises down Sub-Saharan Africa 2015 growth Wall Street Journal, Matina Stevis (27/10/15)
World Economic Outlook, October 2015: Adjusting to Lower Commodity Prices IMF (6/10/15)
Global Growth Slows Further, IMF’s latest World Economic Outlook IMF Podcast, Maurice Obstfeld (6/10/15)
Transcript of the World Economic Outlook Press Conference IMF (6/10/15)
World Economic Outlook Database IMF (October 2015 edition)
- How do we measure economic growth?
- Using an AD/AS diagram, explain why economic growth has fallen in (a) the US, (b) the UK and (c) Africa.
- How have oil prices contributed towards recent growth data?
- Why has the IMF forecast slowing growth for Africa and how dependent is the African economy on growth in China?
- Which sectors are contributing towards slower growth in each of the 3 countries/continents considered? Can you explain the reason for the downturn in each sector?
- What do you think should be done regarding interest rates in the coming months?
In the Blog, A VW recession for the eurozone, as German growth revised down?, we discussed the pessimistic outlook for the eurozone, in part driven by the problems facing the engine of Europe: Germany. While the German government noted that the weak growth figures are due to external factors, it appears as though these external factors are now sending waves through the domestic economy.
Over the past 6 months, German confidence has fallen continuously and now stands at almost its lowest level in 2 years. Think tank data from a survey of 7000 firms in Germany fell from 104.7 to 103.2 for October – the weakest reading since December 2012. Confidence is always a key factor in the strength of an economy, as it affects consumers and businesses. Without consumer and business confidence, two key components of aggregate demand are weak and this downward pressure on total spending in the economy depresses economic growth. An economist from Ifo, the think-tank that produced this business climate index, said that firms felt ‘downbeat about both their current situation and the future.’
As confidence continues to decline in Germany, the economic situation is unlikely to improve. Unfortunately, it is something of a vicious circle in that without economic growth confidence won’t return and without confidence, economic growth won’t improve. The industrial sector is crucial to Germany and the data is concerning, according to Chief economist at Commerzbank, Joerg Kraemer:
The latest numbers from the industrial sector are very worrisome…The third quarter was probably worse than expected, the economy may have stagnated at best.
Numerous factors continue to depress the German economy and while negative growth is not expected, estimates for quarterly growth from July to September remain at around 0.3%. As Europe’s largest economy, such low growth rates will be of concern to the rest of the Eurozone and may also bring worry to other countries, such as the US and UK. With growing interdependence between nations, the success of countries such as Germany and Europe as a whole influences the economic situation abroad. Commentators will be looking for any signal that Germany is strengthening in the coming months and an improvement in business confidence will be essential for any prolonged recovery.
German business confidence falters again in October Wall Street Journal, Todd Buell (27/10/14)
German business morale weakens to lowest level in almost two years Reuters, Michelle Martin (27/10/14)
Zero growth best hope for Germany as confidence disappears The Telegraph, Szu Ping Chan (27/10/14)
German Ifo business confidence drops for sixth month Bloomberg, Stefan Riecher (27/10/14)
German business confidence plunges again as analysts urge fiscal stimulus International Business Times, Finnbarr Bermingham (27/10/14)
German business confidence falls again, Ifo says BBC News (27/10/14)
German business confidence tumbles The Guardian, Philip Inman (24/9/14)
The German way of stagnating BBC News, Robert Peston (11/11/14)
- Why is consumer and business confidence such an important element in explaining the state of an economy?
- Use an AD/AS diagram to illustrate the impact on national output of a decline business confidence. What are the other consequences for the macroeconomic objectives?
- What actions can a government take to boost confidence in an economy?
- If economic growth is weak and confidence is low, is there any point in cutting interest rates as a means of stimulating investment?
- If the eurozone did move back into recession, what could be the possible consequences for countries such as the UK and US?
- How useful are indices that measure business confidence?
The most commonly used measure of economic performance is GDP and while there is agreement that it is an important and useful measure, there is also agreement that there are some big problems with it. Does it measure welfare or quality of life? What is and isn’t included? Do some things add to GDP which actually make us worse off?
One criticism often levelled at GDP is that there are many aspects that go unmeasured – often known as the underground economy. Some areas are typical everyday things – DIY, looking after your own children rather than paying someone to do it, or even giving yourself a haircut. But, there are other activities, often illegal, which go unrecorded, such as the selling and distribution of drugs and prostitution. In countries like the Netherlands, their GDP figures get a boost, as some drugs and prostitution are legal. In other countries, such data is not recorded and as such, the contribution of these markets is under-estimated or even completely omitted.
However, this aspect of the calculation of GDP statistics is changing across Europe, which will allow much easier and more meaningful comparisons of relative GDP across countries. This extra production will therefore offer a positive contribution towards our GDP and perhaps suggest to the untrained eye that the British economy is growing, which can only be good news. But, for the trained economist, we are looking at extra data being added, which will boost total output and the question will be does it really indicate that the economy is better off? The following articles consider this change to GDP.
Small data: The way drugs and prostitution boost the economy BBC News (4/4/14)
Small data: Calculating the sex and drugs economy BBC News (2/6/14)
UK economic output to be revised up after ONS updates BBC News, Anthony Reuben (10/6/14)
UK economic output will get near 5 percent boost from data changes Reuters (10/6/14)
Accounting for drugs and prostitution to help push UK economy up by £65bn The Guardian, Katie Allen (10/6/14)
- What does GDP measure? Is it good at measuring it?
- Explain the pros and cons of using GDP to measure the welfare of an economy.
- Why are there problems using GDP to compare output between countries?
- Is it a good idea to include markets such as sex and drugs in calculating a nation’s output?
- What other measures of welfare do we have?
How much value do you place on that wonderful long weekend that a Bank holiday brings? The extra lie in; the ensuing 4 day week; the time you spend with your family. Some would say it’s invaluable – you can’t put a price on it. But those some people would not be economists! Each Bank holiday is worth about £2bn – at least that’s how much it costs the economy.
According to the Centre for Economics and Business Research, if the UK got rid of its Bank holidays, GDP would increase by approximately £18bn.
Some businesses will do well out the Bank holidays, but according to the research, the sectors of the economy that suffer are far greater, causing losses in productivity and hence in GDP. Indeed, the extra Bank Holiday we had last year for the Royal Wedding is thought to have been part of the cause for the slow down in growth to 0.1% during the second quarter of 2011.
Based on this data, there are unsurprisingly concerns that the extra Bank holiday this year for the Queen’s Diamond Jubilee could also cost the economy. Not particularly good news, considering how vulnerable the economy currently is. Although the Queen’s Diamond Jubilee will undoubtedly generate huge amounts of spending, it is thought that this will be more than offset by the sectors that are expected to lose out because of the loss in working hours and hence productivity.
Given the cost of Bank holidays to the economy, the CEBR says that they should be spread more evenly throughout the year. Is this the solution &ndash if one is needed – or should they be abolished altogether! The following articles consider the issue.
Do we really need bank holidays? Asks CEBR Telegraph, Emily Gosden (30/10/11)
Bank holidays ‘cost economy £18bn’ Independent, John Fahey (9/4/12)
Bank holiday costs UK economy £2.3bn Sky News, Tadhg Enright (9/4/12)
Bank holidays ‘cost economy £19bn’ BBC News (9/4/12)
Bank holidays cost UK economy £18bn and ‘should be spread out’ Mail Online (9/4/12)
- How could we use marginal utility theory to measure the ‘value’ of a Bank holiday?
- Which sectors will generally benefit from Bank holidays?
- Which areas of the economy are likely to contribute towards lost output because of a Bank holiday?
- Why does CEBR suggest that spreading out Bank holidays more evenly across the year would be less costly for economic growth?
- How can the value of lost output during one day be calculated?
- Does a Bank holiday add to somebody’s well-being? How could we measure this?