Nominal GDP is the GDP measured in current prices, without adjusting for inflation. For example, if a country produces 10 apples at $1 each in Year 1 and 10 apples at $1.25 each in Year 2, nominal GDP increases from $10 to $12.50 due to higher prices.
Similarly, Real GDP is the GDP adjusted for inflation, using constant base-year prices to reflect actual production changes. For example, if 10 apples are produced in Year 1 and 10 apples in Year 2, real GDP remains constant regardless of price changes. Real GDP is good because:
- Measures True Growth: Shows changes in economic output without distortions from inflation.
- Comparability: Allows for accurate comparisons over time or between countries.
- Indicator of Living Standards: Real GDP per capita (real GDP divided by population) is used to measure average productivity and quality of life.
To calculate real GDP:
where GDP inflator is the price index that measures inflation across all goods/services in the economy.
Real vs. Nominal GDP Growth
Changes in nominal GDP can result from:
- Changes in Prices: Reflecting inflation or deflation.
- Changes in Quantity: Reflecting real economic growth.
Real GDP focuses only on quantity changes, filtering out price effects.
Example
- Nominal GDP (Year 1): $1,000 (10 units at $100/unit).
- Nominal GDP (Year 2): $1,500 (15 units at $100/unit).
- If prices increased by 20%, the GDP deflator is 120.
Real and nominal GDP are often translated with the usage of price indices and the GDP deflator.