Real vs. Nominal GDP: How Should We Measure Our Welfare?

Tuesday, December 30, 2008  

By Edward Kutsoati

EdwardIt’s been said, over and over again, that "statistics do not lie." But what if you don’t know what to really make of the numbers? In the run-up to the hotly contested December 7 polls, an Accra-based radio station, Joy FM called up Dr. Kwabena Anaman, the Director of Research at the Institute of Economic Affairs to shed light on the progress made in the Ghanaian economy over the past 8 years. Dr Anaman’s answer, that by the end of 2008, the economy will be about one and one-half times its size in 2000, sparked a debate on which statistic, if any, more accurately captures an economy’s progress.

Apparently the vice-presidential candidate for the New Patriotic Party, Dr Mahamadu Bawumia, had asserted at a debate held at Cape Coast in November that the economy almost quadrupled over the eight year period. We now know that, while Anaman measured progress using the real gross domestic product (GDP), Bawumia’s claim of a four-fold growth was based on the nominal GDP.  So who, and which number, should we trust? More importantly, do these numbers matter at all to the average Joe?

First, the basics. The nominal GDP is the value of the goods and services produced in the country in a given year, measured at that year’s prices. So, if two bags of cement were all that the economy produced in 2008, and a bag of cement was priced at GHc10 in 2008, then the nominal GDP is GHc20. The real GDP, on the other hand, is an attempt to measure the actual quantity of goods and services produced, relative to a past (i.e., base) year. To calculate real GDP for the case of the two bags of cement produced in 2008, we estimate their value using prices that prevailed in the base year (say, 2000). So, for example, if back in 2000, each bag of cement cost GHc2, then the real GDP in 2008 is GHc4 (in 2000 constant prices). If further we assume one bag of cement was produced in 2000, then real GDP growth over the eight year period would doubled in real terms. But due to the five-fold rise in prices, nominal value of cement produced is up 10 times.


In actuality, the growth in Ghana’s nominal GDP over the eight year period is about 302%, as reported by the Ghana Statistical Service (GSS). This breaks down into a real GDP growth of 54%, plus the cumulative price changes over the same period (that is, 248%). Clearly, for the purpose of measuring welfare, what matters is the production of real goods and services: people consume goods and services, and not price growth. Were this not true, Zimbabwe, with an inflation rate of a gazillion percent, would have the highest welfare in the world! So if you guessed, as Dr. Anaman claims, that the real GDP provides a better measure of progress, you are correct. But there is a caveat.

As the above illustrates, the difference between the real and nominal GDP is inflation, usually measured by the consumer price index (CPI). In practice, the GSS selects a number of goods and services that are typically consumed by the average household. This allows the GSS to not only track the changes in prices of goods and services, but also determine how such changes impact the cost of living over time. A key question is how has this ‘basket of goods’ itself changed over the last eight years? For example, at the end of 2000, only a few households own mobile phones. Today, millions use mobile phones in their ordinary lives and businesses, and therefore "top-up phone credits" has become part of their ‘basket of goods and services.’ So suppose, in an extreme case, that all the goods we consume today were virtually non-existent in a previous (base) year. Then the nominal GDP provides a better gauge of the nation’s welfare. So too would the nominal GDP matter for welfare if the ‘basket of goods and services’ remained the same, but the quality of individual goods increased over the eight year period. To make the case, suppose we return to the cement example above, and suppose further that the cement produced in the post-2000 years are of higher quality: e.g., you only need half a bag, and lesser amount of sand to build the same durable structure. Then in this case, the increase in prices (as reflected in the nominal GDP) would be justified because households now consume (and pay more for) high quality goods. If there was a systematic increase in the quality of all goods over the years, then the nominal GDP paints a good picture of changes in standards of living. But, has there been a remarkable increase in the quality of goods and services over the last eight years? I think not. 

In any case, this is only part of the reasons why translating real or nominal GDP numbers into welfare can be tricky. It is therefore imperative that the composition of goods and services consumed by the typical household is constantly assessed so we can better evaluate welfare levels. This is one of the main objectives of the series of Ghana Living Standards Surveys, currently in its 5th wave. A more recent base year will also be helpful in this process.

Above all, we know that, in spite of being a more accurate measure of welfare, the real GDP growth alone does not tell the whole story. The 54% increase in real GDP over the eight year translates into an average growth rate of about 5.57% per year. Not a bad record for a country that is making a turnaround from its turbulent past, and beginning to build an enabling environment for private sector growth. However, true progress only begins to occur when such encouraging growth statistics starts to impact the lives of ordinary Ghanaians – in the form of better access to education, health care, and to lines of credit – so they too can unleash their God-given talents. The challenge in the years ahead is to consolidate these recent gains, while creating opportunities for all so that the growth can be more equitably distributed across all income groups.

Edward Kutsoati is Associate Professor of Economics at Tufts University and a regular columnist for