Gross Domestic Product (GDP) is a widely used measure of an economy’s performance. It represents the total value of all goods and services produced within a country’s borders in a given period of time, usually a year or a quarter. The GDP figure is an important economic indicator as it is often used to gauge the health of a country's economy and to compare economies across the globe.
In calculating GDP, there are two key measurements - nominal GDP and real GDP. While both measurements represent the total value of goods and services produced within a country’s borders, they differ in the way they are calculated, and hence, they provide different perspectives on an economy’s performance.
Nominal GDP is the value of all goods and services produced within a country's borders and measured at current market prices. Nominal GDP simply adds up the value of all goods and services produced in a given period, using the prices that prevailed during that period. For example, if a country produces 100 units of a product and sells each unit for $10, the nominal GDP would be $1,000.
Nominal GDP is useful because it reflects the current state of the economy in terms of market prices. It is an excellent indicator of the value of goods and services produced in a given time and tells us how much individuals and businesses are spending in the country. It is also the figure that is most often quoted in the media and used by policymakers to make decisions about the country's monetary policy.
However, nominal GDP does not provide an accurate picture of a country’s economic performance over time. The nominal GDP figure for a country can be affected by changes in the price level of goods and services. When the value of goods and services increases due to an increase in market prices, this increase can be attributed to either an increase in the production of goods and services or the rise in the price of these goods and services. Therefore, it becomes difficult to determine if the increase in GDP is due to economic growth or simply inflation.
Real GDP, on the other hand, takes into account changes in the price level and adjusts the nominal GDP figure for inflation. In other words, real GDP is the nominal GDP adjusted for inflation, calculated using a constant price level from a base year. It measures the real value of goods and services produced in an economy relative to a base year. For example, if the GDP of a country in 2010 was $500 billion and the GDP of the same country in 2020 was $750 billion, the nominal GDP would suggest a 50 percent increase. However, if inflation was 30 percent between 2010 and 2020, the real GDP would show a much smaller increase of only around 16 percent.
Real GDP is a more accurate measure of economic performance over time than nominal GDP because it adjusts for inflation, which means that it measures the actual physical output of goods and services produced. By adjusting for inflation, real GDP accounts for the fact that the prices of goods and services change over time so that changes in the inflation rate do not affect the real value of GDP.
Real GDP is also useful in comparing the economic performance of different countries over time as it provides a common base year that controls for inflation. This allows for a fairer comparison between economies.
Limitations of Nominal and Real GDP
While both nominal and real GDP are useful economic indicators, they both have limitations.
One of the main limitations of nominal GDP is its vulnerability to the effects of inflation. Increases in nominal GDP can often be attributed to an increase in the overall price level rather than actual economic growth. Additionally, nominal GDP does not take into account changes in the economy's growth rate, which can result in a misleading representation of the economy's actual performance.
Real GDP has its own set of limitations as well. One limitation is that changes in the quality and quantity of goods and services produced are not taken into account. This means that improvements in the quality of goods and services that are produced within an economy are not reflected in changes in real GDP, as the measure adjusts solely for inflation. Also, real GDP does not account for non-market activities such as volunteer work and the contribution of the informal economy to a country’s GDP.
Nominal GDP and real GDP are two important economic measures that provide different perspectives on a country’s economic performance. Nominal GDP is the value of all goods and services produced within a country measured at current market prices, while real GDP is nominal GDP adjusted for inflation using a constant price level from a base year. Nominal GDP is vulnerable to inflation, while real GDP takes inflation into account and is therefore a more accurate measure of economic performance over time. Both nominal and real GDP have their limitations and are most effective when used together to provide a comprehensive view of an economy's performance.