What are the disadvantages of using nominal GDP?

There are several disadvantages of using nominal GDP as a measure of economic performance.

1. Inflation distortion: Nominal GDP includes the effects of inflation, which can distort the true economic growth. Inflation refers to the general increase in prices over time, and when calculating nominal GDP, it includes both the increase in prices and the increase in the quantity of goods and services produced. Therefore, if there is inflation, nominal GDP may overstate the actual growth in output, making it difficult to accurately compare economic performance over time.

2. Comparability across time and countries: Due to the inflation distortion mentioned above, nominal GDP figures cannot be easily compared across different time periods or countries. Inflation rates vary across countries and time, making it challenging to make meaningful comparisons using nominal GDP. For example, a country with high inflation may have a higher nominal GDP than a country with low inflation, even if the latter has a higher standard of living.

3. Changes in price levels: Nominal GDP does not account for changes in price levels, which can lead to misleading conclusions about economic performance. For instance, if the price of a specific good or service increases significantly, it may lead to a higher nominal GDP, even if the quantity of goods and services produced remains the same or decreases. This can create a false impression of economic growth or decline.

4. Ignores changes in the composition of output: Nominal GDP does not consider changes in the composition of output, meaning it does not differentiate between changes in the quantity of goods and services produced and changes in the types of goods and services produced. For example, if a country shifts its production from low-value goods to high-value goods, nominal GDP may not accurately reflect the increase in economic welfare resulting from this shift.

5. Does not account for quality improvements: Nominal GDP does not capture improvements in the quality of goods and services produced. As technology advances and products become more efficient or of higher quality, the value of these improvements is not reflected in nominal GDP. This can lead to an underestimation of economic growth and welfare improvements.

In summary, while nominal GDP is a widely used measure of economic performance, it has several disadvantages. It can be distorted by inflation, making it difficult to compare across time and countries. It does not account for changes in price levels, composition of output, or quality improvements, which can lead to misleading conclusions about economic growth and welfare. Therefore, economists often use real GDP, which adjusts for inflation, to provide a more accurate measure of economic performance.