When discussing the performance of a country's economy, terms such as Gross Domestic Product (GDP) are often used. GDP refers to the total value of goods and services produced within a given country's borders. However, there are two types of GDP, namely Nominal GDP and Real GDP.
Nominal GDP refers to the total value of goods and services produced within a given country's borders at current market prices. In other words, this is GDP calculated using the current market prices of goods and services. For instance, assuming that a country produces ten apples at $2 each, and twenty oranges at $3 each, the nominal GDP would be calculated as follows:
Nominal GDP = (10 x $2) + (20 x $3)
Nominal GDP = $20 + $60
Nominal GDP = $80
Here, Nominal GDP is calculated at current market prices.
In contrast, Real GDP refers to the total value of goods and services produced within a given country's borders adjusted for inflation. This means that Real GDP takes into account changes in market prices, as well as inflation. In other words, it takes into account the difference between the current price and the price at which goods and services were sold in the past. To find the real GDP, an inflation adjustment needs to be made to nominal GDP.
For example, if the nominal GDP of a country in the year 2020 was $10 trillion, and the inflation rate for the same year was 2%, then the real GDP could be calculated as follows:
Real GDP = Nominal GDP / GDP deflator
GDP deflator = 100 / (1 + inflation rate)
GDP deflator = 100 / (1 + 2%)
GDP deflator = 100 / 1.02
GDP deflator = 98.04
Real GDP = $10 trillion / 0.98
Real GDP = $10.2 trillion
Here, the GDP deflator is used to adjust for inflation, which results in the real GDP, thus taking into account changes in prices over time.
One key difference between Nominal and Real GDP is that Nominal GDP does not take into account inflation or changes in the price level. Hence, it can often present an inaccurate picture of the country's economic performance. For instance, suppose a country's nominal GDP increases by 10% in a year, but the inflation rate for the same year is 20%. In that case, this increase in nominal GDP could be due to the increased price level rather than increased production, and thus the economy would not have actually grown as much as the nominal GDP suggests.
On the other hand, real GDP incorporates inflation, which provides an accurate measure of economic growth or decline. For example, suppose a country's nominal GDP increases by 10% in a year, with the inflation rate for the same year at 5%. In this case, the real GDP growth would only be 5%, as the extra 5% is attributed to the increase in price level.
Another key difference between nominal and real GDP is that real GDP accounts for changes in the quantity of goods and services produced, while nominal GDP does not. This means that changes in the quantity of goods and services produced would result in changes in real GDP but not necessarily in nominal GDP. It is vital to track changes in real GDP as it indicates the actual production and economic growth of a country, whereas nominal GDP merely reflects the current price level of the country's goods and services.
In conclusion, nominal GDP and real GDP are essential economic measurements that provide a snapshot of a country's economic performance. However, the significant differences between them highlight that nominal GDP alone is not enough to provide a complete and accurate picture of economic growth. Real GDP adjusts for inflation, changes in the price level, and changes in production, allowing policymakers to identify and address factors that affect the economy's long-term performance. Thus it is crucial to pay attention to both nominal GDP and real GDP to evaluate the economic health of any country.