3.2.1.4 - National income and living standards

Nominal and real income

Nominal income is measured in current money prices; real income removes price changes so that a comparison describes purchasing power or the volume of output.

Nominal GDP can rise even if exactly the same goods and services are produced at higher prices. With a price index whose base year equals 100:

In an illustrative economy, Year A nominal GDP is £500 billion and the GDP price index is 100. Year B nominal GDP is £550 billion and the index is 110. Year B real GDP is $550/110\times100=£500\text{ billion}$, unchanged from Year A. The 10% rise in money output is entirely accounted for by the 10% price rise. Dividing by 1.10 is equivalent; multiplying by 1.10 would incorrectly amplify rather than remove inflation.

Use a price measure appropriate to the variable. The GDP deflator reflects prices of output included in GDP; a consumer price index measures the consumer basket and is more suitable for converting a household wage into consumer purchasing power. They need not show the same price changes because their coverage differs. The ONS account of gross and net national measures distinguishes GDP's production basis from other income measures.

For a separate illustrative wage comparison, monthly earnings rise from £2,100 to £2,500, while the consumer price index rises from 100 to 125. The later real wage is $2500/125\times100=£2000$ per month at base-year prices. Money earnings have risen, but their purchasing power is $(2000-2100)/2100\times100\approx-4.76\%$ lower. Subtracting inflation from nominal growth is only an approximation: the exact real-growth factor is the nominal-growth factor divided by the price-growth factor. Deflating values first avoids that approximation.

Real output per person over time

Real GDP per capita divides price-adjusted output by population, allowing us to compare the average volume of output available per person over time.

Continue the illustrative GDP example from the previous part. Population rises from 25 million in Year A to 26 million in Year B. Real GDP remains £500 billion, so output per person falls from $500\text{ billion}/25\text{ million}=£20\,000$ to $500\text{ billion}/26\text{ million}\approx£19\,230.77$. This is a fall of about 3.85%. The real total is unchanged, but more people share it. Dividing £550 billion by 26 million without deflating first would leave the price effect in the comparison.

Keep units consistent: a billion divided by a million is a thousand, so 500 billion divided by 25 million is 20 thousand, not 20 pounds. Record the year and price basis, and use comparable population estimates. For growth rates, the exact per-capita growth factor is the real-GDP growth factor divided by the population-growth factor. If real GDP grows by 4% and population by 2%, output per person grows by $(1.04/1.02-1)\times100\approx1.96\%$, not exactly 2%.

Higher real output per person can support greater consumption, investment and public services. It is therefore useful evidence about material possibilities. It is not automatically an increase in every household's disposable income: GDP is domestic production, not a sum distributed equally to residents. Income paid abroad, taxes, saving and the distribution of gains all affect households' experience.

UK pandemic evidence also illustrates the need to check definitions and data vintages. The ONS release of 12 February 2021 initially estimated 2020 real GDP falling by 9.9% and real GDP per head by 10.5%. Those are explicitly dated estimates, subject to later revision. The same release warned that countries' different methods of measuring health and education output reduced international comparability during the pandemic. A careful judgement uses comparable measures and recognises those limits, rather than treating a reported decimal as exact knowledge of welfare.

Purchasing power parity between countries

Purchasing power parity (PPP) conversion adjusts for differences in price levels between countries so that income comparisons better reflect the goods and services it can buy.

Converting local GDP into a common currency using the market exchange rate is necessary to compare money values, but may misrepresent domestic purchasing power. Non-traded services such as haircuts can be much cheaper in one country. Financial flows can also move a market exchange rate without an equivalent immediate change in the country's real output. PPP uses comparisons of prices for comparable goods and services instead.

Suppose a comparable basket costs 100 US dollars in the reference economy and 200 tokens in Country A. The illustrative PPP conversion factor is 2 tokens per international dollar. An international dollar has the purchasing power of a US dollar in the reference economy for the comparison; it is a statistical unit, not money a household can exchange at a bank. If the market rate is 4 tokens per US dollar, the basket appears to cost only 50 US dollars at the market rate. The same local income consequently buys more domestically than its market-dollar value suggests.