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(Measurement of Gross Domestic Product (GDP) in Current Price and Constant Price).

Definition Nominal GDP:

The 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:

Example:

Let us assume that an economy produces 100 pens and 50 books in the year 2020. 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 2020.

(100 pens x $1 per pen) + (50 books x $2 per book)

($100) + ($100)

$200

Suppose that in the year 2021, the production of the two goods, pen and book remains the same, but their prices get doubled. The total value of the goods then would be $400.

(100 pens x $2) + (50 books x $4)

($200) + ($200)

$400

The nominal GDP in the year 2020 is $200 and is $400 in the year 2021. 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.

Definition 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.

Calculation with Example:

Let us take a simple example of two goods economy for two years to explain the concept of Real GDP. The table given below shows the nominal GDP for the two years 2001 and 2002.

Calculating the Nominal GDP:

Calculating the Real GDP:

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 Overtime:

We can measure the changes in prices of goods overtime by an index called GDP Deflator.

Definition of GDP Deflator:

GDP deflator is a measure of the price level calculated as the ratio of nominal GDP to real GDP times 100.

Formula for GDP Deflator:

Calculating the GDP Deflator:

For the year 2002, the value of GDP deflator as worked out is $171 and was 100 in the base year. This means that the price level has increased by 71% from the base year.

Definition of Base Year:

The year from which a financial or economic index is first calculated. It is normally set at an arbitrary level of 100. Any year can be chosen as a base year, but it is generally desirable to use a fairly recent one. New, more up to date base years are periodically introduced. An average value for a number of years can also be used as a base year.