Question

What is the difference between Nominal GDP and Real GDP? How can the ratio of Nominal to Real GDP indicate how much inflation an economy has been experiencing?

Answer 1

Nominal GDP measures the GDP at current market prices and current quantities.

Real GDP measures the GDP at base year prices and current quantities.

Thus, the main difference is:

the prices are kept constant in Real GDP as per the base year; while in Nominal GDP, prices are allowed to vary every year.

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To explain in more detail, GDP is the market value of all final goods and services produced by a country during a given period.

For example, the market value of all cars produced will be:

(Market price of a car) x (Number of cars produced)

GDP is (P x Q) across all goods and services.

If cars are denoted by (P₁ x Q₁), note that there may be n number of goods and services. GDP will cover all goods and services, which may be thousands for a country.

In mathematical terms,

Now in the above formula, Nominal GDP will take the Price of the good afresh, every year.

Real GDP will fix the price in some base year, and it won't change until the next base year is selected.

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Now, the ratio of Nominal to Real GDP gives us the GDP Deflator. It is actually a price index.

(Nominal GDP / Real GDP) x 100 = GDP Deflator

It shows us how the price level has changed from base year to the current year. The GDP deflator is always 100 in the base year.

As prices grow, the GDP deflator rises. If prices fall, the GDP deflator falls.

Thus, the rate of change of the GDP deflator is also the inflation rate. This inflation rate will be economy-wide, and will portray the inflation across all goods and services.