What is the relationship between inflation, nominal GDP growth and real GDP growth?

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Expert Solution

Inflation is the increase in the general average price level of a selected bundle of goods and services in an economy over a period of time. Inflation increases the money supply in the economy, decreases the rate of unemployment as demand for goods increases but decrease the purchasing power of the people. Thus inflation is good for the economy but it should be maintained as targeted by the central bank of the country.

Real GDP (real gross domestic product) is the value of all the goods and services produced within the domestic territory of the country in an accounting year. This shows the adjustment with inflation. Real GDP is expressed in terms of price of the base year and often referred to as constant price.

Nominal GDP is the value of all the goods and services produced within the country in an accounting year calculated on the basis of the current price. This is expressed in monetary units taking changes in prices. It changes due to change in quantity and price. It does not show adjustment of inflation as real GDP does.

Real GDP is the multiplication of the quantity of current year and price of the base year.

Nominal GDP is the multiplication of quantity and price of the current year.

Nominal GDP is equal to real GDP in the first year as the base year and the current year is the same.

Inflation rate depends on GDP deflator of the base year and current year which is obtained by real and nominal GDP.

The GDP deflator is equal to the ratio of nominal GDP and real GDP into 100.

GDP Deflator= Nominal GDP/Real GDP * 100

From the above equation, the inflation rate is calculated:

(GDP deflator of the current year - GDP deflator of the base year) divided by GDP deflator of the base year.

Therefore these formula explains the relation between inflation, real GDP and nominal GDP.

When inflation increases, real GDP also increases in the short run. Thus inflation, real GDP and nominal GDP are related to each other.

Rahul Sunny answered 9 months ago

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