Measurement of Gross Domestic Product (GDP) in Current Price and Constant Price or Difference Between Nominal GDP and Real 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 of two good economy and two years.

Example:

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)     =     $200

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.

(100 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.

Definition and 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.

Example For 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 Nominal GDP:

Calculating 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:

GDP Deflator = Nominal GDP x 100

                                                                                  Real GDP         1

Calculating the GDP Deflator: