Real GDP vs Nominal GDP: GDP Deflator

REAL GDP :

Goods and services produced are evaluated at constant prices ie base year (2011-12), so Real GDP changes only if production changes.

NOMINAL GDP : 

Goods and services produced are evaluated at prevailing market prices, so Nominal GDP changes with production and prices as well.

 

For ex:

If we have to calculate the GDP in 2023-24, then real GDP in 2023-24 is calculated at prices prevailing during the base year (2011-12),

                                                                         while 

Nominal GDP in 2023-24 is calculated at prices prevailing during the current year (2023-24),

Significance of Nominal GDP: 

• Nominal GDP is often used to measure short-term economic performance since it reflects actual market conditions. 
• From the government's perspective, Nominal GDP is a more accurate reflection of economic growth as it affects the citizens directly.

However, it can be misleading when comparing data from different years because it does not account for those changes in purchasing power caused by inflation or deflation.

Significance of Real GDP: 

• Real GDP takes into account changes in quantities produced, providing a more realistic picture of economic health and expansion. 
• Investors often consider real GDP when assessing potential investment opportunities because it provides a clearer understanding of an economy's performance. 
• It eliminates the impact of varying price levels across countries. 
• When comparing nominal GDP, differences in exchange rates can distort the true economic growth rate between countries. However, by using real GDP, these fluctuations are accounted for, enabling a more accurate assessment of economic performance.

HOW REAL GDP GIVES BETTER PICTURE OF THE ECONOMY :

For example, 

let's say Country A had a nominal GDP growth rate of 5% with an inflation rate of 4%, while Country B had a nominal GDP growth rate of 3% and  an inflation rate of only 1%,

At first glance, it may seem that Country A performed better economically. 

However, When we calculate the real GDP growth rates for both countries by adjusting for inflation, we find that Country A's real GDP growth rate is only 1%, while Country B's real GDP growth rate is 2%. In this case, even though Country A had a higher nominal GDP growth rate, it actually performed worse than Country B when considering changes in actual production.

GDP Deflator :

Ratio of Nominal GDP to Real GDP is GDP deflator. It expresses the inflation across the GDP .

GDP Deflator vs. CPI Index :

• Both measure inflation but important differences often cause them to diverge. 
• GDP deflator reflects prices of all goods/services produced domestically in the economy while CPI index reflects prices only a market basket of some goods/services which got changing with revision in the basket. 
• GDP deflator is broader index than CPI but excludes imports. while CPI is Narrow consumer index but includes imports .