Economics · Ch 2 — National Income Accounting
Nominal and Real GDP
Nominal and Real GDP
2.4 Nominal and Real GDP
The Problem of Changing Prices
Up to this point, we have been working with GDP as if prices never change. That assumption is convenient for building basic concepts, but it is unrealistic. In the real world, prices rise and fall over time. When they do, comparing GDP figures from different years becomes misleading.
Suppose a country's GDP doubles from one year to the next. You might think the country is producing twice as many goods and services. But it is equally possible that production stayed exactly the same while every price in the economy doubled. The GDP figure would double in either case, and the raw number alone cannot tell you which scenario actually happened.
This is why economists distinguish between two kinds of GDP: nominal GDP and real GDP.
Nominal GDP
Nominal GDP is the value of all final goods and services produced in a country during a given period, measured at the prices that prevail in that same period. It is the GDP figure you get by simply multiplying current-year quantities by current-year prices and adding them up. No adjustment for price changes is made.
Nominal GDP is sometimes called "GDP at current prices." It is the number that statistical agencies first report, before any inflation adjustment.
Real GDP
Real GDP removes the effect of price changes by valuing all goods and services at a fixed set of prices from some chosen year, called the base year. Because the prices used do not change, any movement in real GDP must come from a change in the actual volume of production — the quantity of goods and services produced.
Real GDP is the measure that tells you whether an economy is genuinely producing more (or less). Nominal GDP can rise even when production falls, if prices rise enough. Real GDP cannot rise unless production rises.
A Simple Numerical Example
The textbook works through a one-good economy that produces only bread.
- Year 2000 (base year): 100 units of bread are produced at ₹10 per bread. Nominal GDP = 100 × ₹10 = ₹1,000.
- Year 2001 (current year): 110 units of bread are produced at ₹15 per bread. Nominal GDP = 110 × ₹15 = ₹1,650.
Now compute real GDP for 2001 using 2000 as the base year. The quantity is 110 units (the current year's production), but the price is the base year price of ₹10. So real GDP = 110 × ₹10 = ₹1,100.
Notice what has happened. Nominal GDP rose from ₹1,000 to ₹1,650 — an increase of 65%. Real GDP rose from ₹1,000 to ₹1,100 — an increase of only 10%. The difference between the two growth rates is entirely due to the rise in the price of bread from ₹10 to ₹15.
The GDP Deflator
The ratio of nominal GDP to real GDP gives a single number that summarises how prices have moved from the base year to the current year. This ratio is called the GDP deflator.
In the bread example:
This number tells us that the price level in 2001 is 1.5 times the price level in 2000. That matches the fact that bread prices rose from ₹10 to ₹15 — exactly 1.5 times.
The deflator is often expressed as a percentage. To do that, multiply the ratio by 100:
In the example, that gives 150%. A deflator of 150% means the general price level has risen by 50% since the base year.
A GDP deflator of 100% means prices are exactly the same as in the base year. A deflator below 100% means prices have fallen (deflation). A deflator above 100% means prices have risen (inflation).
The same logic applies to other national income aggregates. Just as we have a GDP deflator, we can construct a GNP deflator by taking the ratio of nominal GNP to real GNP.
The Consumer Price Index (CPI)
The GDP deflator covers all goods and services produced within a country. But that is not the only way to measure price changes. Another widely used measure is the Consumer Price Index (CPI).
The CPI measures the cost of a fixed basket of goods and services purchased by a typical consumer. It answers a different question: "How much more (or less) does it cost a representative household to buy the same set of goods today compared to the base year?"
How CPI Is Calculated
- Choose a base year and a current year.
- Select a basket of commodities that a representative consumer buys. The quantities in this basket are fixed — they do not change when prices change.
- Calculate the total cost of buying that basket in the base year.
- Calculate the total cost of buying the same basket in the current year.
- Express the current-year cost as a percentage of the base-year cost.
A Two-Good Example
The textbook uses an economy that produces only rice and cloth. A representative consumer buys 90 kg of rice and 5 pieces of cloth per year.
Base year: 2000
- Rice: ₹10 per kg → cost = 90 × ₹10 = ₹900
- Cloth: ₹100 per piece → cost = 5 × ₹100 = ₹500
- Total cost of basket in 2000 = ₹900 + ₹500 = ₹1,400
Current year: 2005
- Rice: ₹15 per kg → cost = 90 × ₹15 = ₹1,350
- Cloth: ₹120 per piece → cost = 5 × ₹120 = ₹600
- Total cost of basket in 2005 = ₹1,350 + ₹600 = ₹1,950
Now compute the CPI:
This means the cost of living for the representative consumer has risen by about 39.29% between 2000 and 2005.
Wholesale Price Index (WPI)
Many goods have two sets of prices. The retail price is what a consumer actually pays at the shop. The wholesale price is the price at which goods are traded in bulk between businesses. These two prices can differ because traders add a margin.
Goods that are traded in bulk — raw materials, semi-finished goods, industrial inputs — are not bought by ordinary consumers. For these goods, a separate index is constructed: the Wholesale Price Index (WPI). In the United States, this is called the Producer Price Index (PPI).
Why CPI and GDP Deflator Differ
The CPI and the GDP deflator both measure price changes, but they can give different numbers. There are three main reasons. …