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
- Recovery during a pandemic
- IMF World Economic Outlook Database
- Gross Domestic Product
World Economic Outlook October 2021
IMF
ONS time series data and publications
Articles
- UK growth downgraded as IMF warns of vaccine gap between rich and poor countries
- Summer slump for UK GDP and IMF warning put economy on the backfoot
- IMF cuts global economic forecast as pandemic ‘hobbles’ growth
- Could inflation wreck the recovery?
- Nations must be ‘absolutely vigilant’ about inflation, says IMF
- UK tops G7 growth league with economy to expand 6.8 per cent this year
Independent, August Graham (13/10/21)
Evening Standard, Oscar Williams-Grut (13/10/21)
Guardian, Larry Elliott (5/10/21)
Daily Mail, James Tapsfield (12/10/21)
BBC News (13/10/21)
City A.M., Jack Barnett (12/10/21)
Questions
- 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’.
- What do you understand by the term hysteresis? By what means can hysteresis effects be generated?
- 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.
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 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 
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 
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 
With the UK parliament in Brexit gridlock, the Labour opposition is calling for a general election. Although its policy over Brexit and a second referendum is causing splits in the party, the Labour party is generally agreed that pubic expenditure on health, education and transport infrastructure needs to increase – that there needs to be an end to fiscal austerity. However, to fund extra public expenditure would require an increase in taxes and/or an increase in government borrowing.