gross domestic product (GDP) is the total market value of all the
final goods and services produced within an economy in a given year. When all
the components of GDP are valued a their current prices in the market, it is
called nominal gross domestic product. Nominal GDP measures
national income ruling at the time and thus takes no account of inflation.
In many applications of macro economics, the
nominal GDP is not
considered a measure of growth and welfare. Why this is so is explained by
taking a simple example of two good economy and two years.
Let us assume that an
economy produces 100 pens and 50 books in the year 2001. The , price of
one pen is $1 and that of the book is $2 in the market. The total
value of the goods produced is $200 in the year 2001 .
(100 pens x $1 per pen) + (50 books x
$2 per book)
(100) + (100)
Suppose that in the year 2002,
the production of the two goods, pens and books remains the same, but their prices get doubled. The total value
of the goods then would be $400.
pens x $2) + (50 books x $4)
200 + 200 = $400
The nominal GDP in the year 2001
is $200 and is $400 in the year 2002. The nominal GDP has increased by 100% even though the physical
production of goods has remained the same. So, if we use the nominal GDP
to measure growth of the economy, we will be misled into thinking that
production has grown. What all has really happened is a rise in the price level.
The standard of living of the people will increase only if (i) the economy produces larger quantity of goods than the previous year and (ii) the goods
are sold at normal prices in the market.
The economists while studying the changes in the economy need a measure of
output which shows an actual increase in production of goods and it is not
affected by changes in their prices. To get this problem solved, the
economist use a measure called Real GDP.
Explanation of Real GDP:
Real gross, domestic product
(Real GDP) is the production of goods and
services valued at constant prices. It is also defined as GDP adjusted for
price changes. It is a measure of output that reflects actual income in.
production, separate and part from any price changes that may have occurred in
the economy during the year.
Calculating Nominal GDP and Real GDP:
Let us take a simple example of a two good economy and of two years to
explain the concept of Real GDP. The table given below shows the nominal GDP for
two years 2001 and 2002.
Price and Quantity
Calculating Real GDP:
($1 per pen x 100 pens) + ($2
per book x 50 books) = $200
($1 per pen x 150 pens) + ($2
per book x 100 books) = $350
We find that real GDP has increased from
$200 in the year 2001 to $350 in
the year 2002. This increase is due to increase in quantities of goods produced
because the prices are held fixed at base year levels. The real GDP enables us
to see how much real income has changed from one year to another.
Measuring Price Changes
We can measure the changes in prices of goods overtime by an index called
Definition of GDP
GDP deflator is a measure of the price level calculated as the
ratio of nominal GDP to real GDP times 100.
Formula For GDP
GDP Deflator = Nominal GDP x 100
$200/$200 x 100 = 100
$600/$350 x 100 = 171