3.4 Interpreting GDP (2024)

The total output of an economy, GDP, provides a measure of the economy’s capacity to produce the goods and services that we need or enjoy, such as food, education, and government services. Dividing GDP by the size of the country’s population gives us GDP per capita—that is, average income—which is a widely used measure of the average living standards in a country. GDP per capita is also highly correlated with other measures of living standards, such as life expectancy.

GDP per capita is not a perfect measure of living standards. It does not include many important aspects of our well-being, including leisure time and the quality of our physical and social environment. Nor does it allow for how equally or unequally incomes are distributed. But provided that we keep these limitations in mind, it can be useful for assessing how incomes are changing over time, and for comparisons between countries.

Comparing income at different times, and across different countries

Before we can make a statement like: ‘On average, people in Italy are richer than people in China, but the gap between them is narrowing,’ statisticians and economists must try to solve an important problem: we need to separate the thing we want to measure—changes or differences in amounts of goods and services—from things that are not relevant to the comparison, especially changes or differences in the prices of the goods and services.

• When comparing output in one country at two points in time, it is necessary to take into account differences in prices between the two points in time.
• When comparing output between two countries at a point in time, it is necessary to take into account differences in prices between the two countries.

The challenge is to find a set of prices to use in our calculations that will allow us to identify changes or differences in outputs sold, without including changes in prices.

The starting point: Nominal GDP

When estimating the market value of output in the economy as a whole for a given period, such as a year, statisticians use the prices at which goods and services are sold in the market, referred to as ‘current prices’. By multiplying the quantities of the vast array of different goods and services by their prices, they can be converted into money, or nominal, terms. With everything in the common unit of nominal (or money) terms, they can be added together. Nominal GDP is written like this:

\[\begin{align*} &\text{(price of a yoga lesson)} \ \times \text{(number of yoga lessons)} \\ &+ \text{(price of a book)} \times \text{(number of books)} + … \\ &+ \text{(price)} \times \text{(quantity)} \hspace{0.2cm} \text{for all other goods and services} \end{align*}\]

In general, we write that:

\[\text{nominal GDP} = \sum_{i}p_iq_i\]

Where \(p_i\) is the price of good \(i\), \(q_i\) is the quantity of good \(i\) sold, and \(∑\) indicates the sum of price times quantity for all the goods and services that we count.

Taking account of price changes over time: Real GDP

To gauge whether the economy is growing or shrinking, we need a measure of the total quantity of goods and services sold. This is called real GDP. If we compare the economy in two different years, and if all the quantities stay the same but the prices increase by, say, 2% from one year to the next, then nominal GDP rises by 2%, but real GDP is unchanged. The economy has not grown.

However, it is not straightforward to calculate real GDP and therefore to know whether it has grown or not. The reason is that it is not possible to estimate the quantity of real GDP directly. The number of computers, shoes, restaurant meals, flights, fork-lift trucks, and so on sold cannot be added together without using prices. The first step in estimating real GDP is to estimate nominal GDP because we can add together the quantity times the price of each product (now in dollars, for example).

The second step in tracking what is happening to real GDP is to pick a base year: for example, the year 2020. We then define real GDP using 2020 prices as equal to nominal GDP that year. The following year, nominal GDP for 2021 is calculated as usual using the prices prevailing in 2021. There will typically be different quantities of the various goods and services produced each year (for example, more computers but fewer flights) as well as different prices for them. Next, we can estimate what has happened to real GDP by multiplying the 2021 quantities by the 2020 prices. If, using the base year prices, GDP has gone up, we can infer that real GDP has increased.

constant prices

To compare the value of goods and services bought or sold at different times we need to allow for changes in the value of the currency in which they are measured (inflation or deflation). To do this, we choose a base year, and then calculate the value of goods and services in other years using the prices in the base year: that is, at constant prices.

If this method produces the result that, when computed using 2020 prices, GDP in 2021 is the same as in 2020, we can infer that although there might have been a change in the composition of output (fewer flights taken but more computers sold, for example), the overall quantity of output of goods and services has not changed. The conclusion would be that real GDP, which is also called GDP at constant prices, is unchanged. In real terms, the growth rate of the economy is zero.

Figure 3.6 plots data for UK GDP in real and nominal terms from 1980 to 2022. Each series is calculated as an index with the year 2000 set equal to 100. This enables a comparison between the two series and shows that even in the era of moderately low inflation, it is essential to correct GDP for changes in the price level: the series for real GDP grows much more slowly than for nominal GDP.

The choice of real or nominal GDP

A simple rule of thumb helps you to decide whether to use real or nominal GDP. Use data in current prices, that is, nominal GDP, when calculating shares of GDP or ratios to GDP, and otherwise, use real GDP.

Using nominal GDP: Aggregates expressed as a percentage of GDP enable comparisons to be made over time and across countries that are independent of the size of the country and that are not affected by changes in prices. As both the numerator and denominator are expressed in nominal terms, the ratio can equally well be thought of in real terms. An example clarifies: the share of consumption in GDP can be written as

\[\frac{C}{PY} = \frac{C/P}{Y}\]

where the left-hand expression shows consumption in nominal terms divided by GDP in nominal terms. The letter \(Y\) is used to refer to real GDP, so multiplying by the price level, \(P\), gives nominal GDP. Dividing numerator \((C)\) and denominator \((PY)\) by the price level, \(P\), gives consumption in real terms divided by real GDP.

The data shown earlier, about the shares of expenditure in GDP or the shares of different industries in GDP or income shares, uses nominal values in the numerator and in the denominator. Another common use for nominal GDP is the calculation of a country’s budget deficit and debt ratios.

Using real GDP: To gauge the size and growth of an economy, assess GDP per capita, and make cross-country comparisons, it is essential to employ real GDP, which takes account of the impact of variations in prices.

Taking account of price differences among countries: International prices and purchasing power

Go to a website called Numbeo to explore detailed cost-of-living comparisons for cities across the world. In the Stockholm–Jakarta comparison, data on price differences across different goods and services (as of October 2023) shows that Nike running shoes are only 10.1% cheaper in Jakarta, while a three-course meal for two in a mid-range restaurant is 69.2% cheaper.

To compare GDP per capita across countries, we need to choose a set of prices and apply it to both countries. If we don’t do this, comparisons are misleading. To understand this, consider two countries at very different levels of development—Sweden and Indonesia. Because prices are so much lower in Indonesia than in Sweden, to maintain the same standard of living in their respective capital cities—Jakarta and Stockholm—you would need $2,455 per month in Jakarta as compared with $4,899 per month in Stockholm. Yet the dollar comparison would suggest your living standard is half as high in Jakarta!

exchange rate

The number of units of home currency that can be exchanged for one unit of foreign currency. For example, the number of Australian dollars (AUD) needed to buy one US dollar (USD) is defined as number of AUD per USD. An increase in this rate is a depreciation of the AUD and a decrease is an appreciation of the AUD.

purchasing power parity (PPP)

PPPs are price indices that measure how much it costs to purchase a basket of goods and services compared to how much it costs to purchase the same basket in a reference country in a particular year, such as the United States in 2011.

The calculation that finds you need half the monthly dollar income to achieve the same standard of living in Jakarta and Stockholm uses a common set of prices to make the comparison rather than the simple use of the dollar exchange rate. This is why when comparing living standards across countries, we use estimates of GDP per capita in a common set of prices known as purchasing power parity (PPP) prices. As the name suggests, the idea is to achieve parity (equality) in the real purchasing power.

Prices are typically higher in richer countries—as in our example. One reason for this is that wages are higher, which translates into higher prices. Because prices of cappuccinos, restaurant meals, haircuts, most types of food, transport, rents, and most other goods and services are more expensive in Sweden than in Indonesia, once a common set of prices is applied, the difference between GDP per capita in Sweden and Indonesia measured at PPP is smaller than it is if the comparison is made at current exchange rates.

Comparisons between the value of output in two countries are generally performed by converting the value of GDP of each country into US dollars and then comparing them. Conversion to dollars can be done either using market exchange rates—from the foreign exchange market—or purchasing power parity (PPP) exchange rates (the rate at which the currency of one country would have to be converted into that of another to purchase the same amount of goods and services in each country).

Zooming out from the comparison of living standards in the capital city to consider the entire economy, GDP per capita in Indonesia in 2022 when measured at the market exchange rate was 8.6% of the level of Sweden; at PPP where the comparison uses international prices, GDP per capita in Indonesia is 22.7% of the level of Sweden.

What this comparison shows is that the buying power of the Indonesian rupiah compared to the Swedish krona is more than two and a half times greater than would be indicated by the current exchange rate between the two currencies.

Figure 3.7 uses GDP per capita data in purchasing power parity terms to compare the evolution of this measure of living standards across countries. GDP per capita in the US is set at 100 in each year. The series for China is smoother than for the other countries. This is because quarterly data is not available on the same basis and the annual data was used. The chart illustrates how China continues to catch up to per capita GDP in the high-income countries. The gap widens between the US and the three European countries over this period, although less for Germany than for the UK and France. China’s experience in and after COVID-19 was different from the other economies.

Measurement issues: How accurate is GDP?

When well funded as in high-income countries, statistical agencies dedicate extensive time and expertise to providing accurate estimates of GDP. Nonetheless, there are facets of the measurement process which pose particular challenges. For example, challenges relate to changes in the quality of goods, non-market activity such as household and volunteer work, and the underground and illegal economy. There are also issues which limit the usefulness of GDP per capita as a measure of living standards; one of these—production which increases GDP but leads to the depletion of natural resources—is discussed in Extension 1.2 of the microeconomics volume.

Quality change

We stressed the important distinction between real and nominal GDP. But in practice, distinguishing between changes in nominal GDP resulting from price fluctuations and those arising from quantity variations can be challenging. The distinction becomes complex with some services, which constitute a significant portion of GDP. For instance, an increase in the nominal premium for an insurance policy may reflect a price hike by the insurer or an improvement in the policy’s quality, such as reduced excesses or expanded coverage. The latter should be recorded as a change in real terms (that is, in quantity) since the real value to the policyholder has increased.

Quality changes are not limited to services; many goods, like mobile phones, also undergo rapid quality improvements over time. Simply counting the number of mobile phones doesn’t suffice; assessing and accounting for quality changes are essential for accurate national accounting, and quality adjustments should ideally be applied to consumer price indices as well to differentiate genuine inflation from price increases associated with enhanced quality.

Non-market activity

A substantial amount of measured GDP (around 30%) is non-market activity. However the only non-market activity that is included in GDP is government spending on goods and services, for example on schools, prisons, and defence. National statistical offices explain that including more non-market activity such as households’ production would be difficult because of the challenges of making market value estimates.

Non-market activity includes work that is unpaid, such as the work of a volunteer fire brigade, or the care that parents provide for their own children. Much of the latter work is done by women, which likely accounts for the conventional view among economists that its omission was a minor problem. However, the UK’s Office for National Statistics did the work to show it is not a minor omission from GDP: in 2016, the value of the UK’s unpaid household service work was estimated at £1.24 trillion—larger in size than the non-financial business sector and equivalent to 63% of GDP. Together, unpaid transport services (such as driving yourself and others to work) and childcare services made up over half of this amount.¹

Some activities which were previously included as market activity have become part of home production as firms’ contact with customers increasingly takes place via the internet or via self-service checkouts, for example. This includes services related to banking and insurance as well as services previously provided by travel agents.

Underground and illegal economy

The treatment of the underground and illegal economy in measuring a country’s GDP varies. Many European countries incorporate certain aspects of illegal-market activity into their industry accounts. Specifically, they include drug dealing within retail subsectors, marijuana cultivation within agricultural subsectors, methamphetamine production within chemical subsectors, and prostitution within personal services.

In the US, this activity is generally not included in GDP. However, researchers at the Bureau of Economic Analysis (BEA) in the US have estimated that the value of illegal activities was worth 1.67% of nominal GDP in 2017, which includes theft from businesses, consumption of drugs, prostitution, and gambling.