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Sunday, June 17, 2012

Nominal GDP vs. Real GDP

GDP (Gross Domestic Product) is the sum of the values of all the goods and services produced in a country. Nominal GDP is evaluated at the current market prices. Prices of goods and services keep on changing and nominal GDP reflects current prices.
Simply put, Nominal GDP does not factor-in the inflation (or deflation, as the case may be).
 On the other side, Real GDP or constant GDP is evaluated at the prices of some base year.

Let us make it simple-

Suppose our base year is 2010 and for this year 2010 Real GDP and the nominal GDP will be same.
But in the next year, 2011, prices shall not remain the same and Real GDP and the Nominal GDP shall differ.
Suppose a country produces goods and services worth $ 100 and $120 in the year 2010 and 2011 respectively. But prices of goods and services too increased in the year 2011, if we calculate the 2011-GDP at the prices of the year 2010, it comes as $ 112-and this Real GDP.

Nominal GDP
Real GDP
$ 100
$ 100
$ 112

This means, though Nominal GDP growth is 20%, Real GDP growth is far less at 12%.

Why real GDP growth rate are used?

Real GDP growth rate shows the true picture of an economy and this why unless mentioned ‘GDP Growth Rate’ figures are of ‘Real-GDP Growth Rate’ only.
If in some particular year,  a country observes heavy inflation in its economy, its Nominal GDP shall shoot and this may give the false impression of growing economy.
Real GDP growth rate removes this anomaly and gives the true picture of the actual growth in the economy.

How Nominal GDP and Real GDP are related?

Real GDP= (Nominal GDP X 100)/ GDP Deflator
This GDP deflator is 1 for the base year and thus for the base year Real GDP equals to the Nominal GDP.

Is GDP Deflator is same as CPI (Consumer Price Index)?

GDP deflator differs from the CPI in two ways-
(1)    CPI does not consider all the goods traded in a country and instead uses a basket of pre-defined goods which are essential for households.
(2)    CPI uses fixed quantities of goods (and this is termed as weight) which were fixed for the base year.


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