Difference Between Real GDP and Nominal GDP

The economy is the string of correlated processes that establish the distribution of the national estate. These actions decide the yield, dispersion, and utilization of goods and facilities, along with other factors. The resources are an essential requirement for those in need. Financial experts have set many economic standards to calculate the national measure of financial management, such as Employment, Market Rates, Industrial Figures, and GDP. To ensure that the nation's economy stays stable, GDP estimation is a necessary measure to take.

GDP is an abbreviation for Gross Domestic Product. The economic value of goods and amenities the country provides to its citizens for a particular period and acquired by an eventual user comes under GDP. It also includes all productions made by the country within its national boundaries. Education, defense, water, electricity, and sanitization are the services that require taxes from the citizens as they are part of collective public demand from the government.

Measuring the GDPs of all employments is not possible. The unpaid social services and laundered money are difficult to keep account of since the banks are hardly concerned in these cases. The significant factor of GDP is that the end product should reach the citizens and contribute to national development. For example- If a person buys cloth to make a dress so that they can acquire profits by selling it, these services are added to GDP because this person supplies the end product (dress). However, if this person decides to use the cloth for his family instead of letting it continue its journey in the market, it will be added as an expense, not a benefaction towards GDP.

Practices for Measuring GDP

Three approaches are singled out for calculating GDP

1. Approach by Calculating Expenditures

The calculation of goods and services bestowed by the government and private sector to its citizens, whether they are foreign or native, within the national boundaries, based on the amount they were bought for. This process is used to calculate total expenses.

Important Terms

• When individuals buy goods using their income, this is known as Consumption Expenditure. For example - Food, appliances, clothes, etc.
• Government programs and development projects come under the Government Expenditure For example- National scholarships, construction projects, etc.
• If the company from the private sector decides to invest in projects, development plans, or shares of other businesses, these expenditures are known as Investment Expenditures. For example- acquiring land, software companies
• Net Exports: The goods exported overseas are added to the net GDP, while the imported goods are eliminated from the GDP. This method is used to calculate the total output gained as end products.

2. Approach for Calculating GDP Through Net Income

The elements that serve as a requisite for earning total income through the yielding of stocks, including taxes, depreciation, and NFI for a native citizen, is known as Net income. All these factors come together to form an economy. Manufacturing goods' constituents are the investments made for acquiring the final byproduct. For example- plot, employment, revenues, and politics that come under the national jurisdiction.

Factors Affecting the GDP

• The overall sum of allowance, lease, returns, and expediency within the national boundaries is known as Total National Income.
• The difference between Gross National Product and Gross Domestic Product is known as Net Foreign Factor Income (NFFI). In other words, the difference between the income generated by individuals in companies that originated in foreign lands and the income generated by foreign individuals in the place of the company's descent is NFFI. It does not play a significant role in evaluating GDP because many foreign companies have a different system of managing the incomes of foreign and native citizens.
• The depletion in the amount of an asset in the reserved time is called depreciation.
• The extra charge added for the goods the citizen purchases is known as sales tax.

3. Approach for calculating the GDP through the Production method

The GDP value could be calculated by measuring the market value of all manufactured goods produced in the country and eliminating the sales taxes from it. Only the real GDP is calculated using this method to avoid any miscalculation due to the constant price change.

The National Statistical Agency gathers data from various sources to evaluate a country's yearly GDP. The International account of GDP is gathered by organizations such as World Bank, the European Commission, the OECD, the International Monetary fund, and the United Nations and stored in a manual known as the System of National Accounts. Many countries follow these official principles for measuring GDP.

Comparison of GDPs of Different Countries

The currencies vary for different countries, and that's why the values of currencies need to be converted into common currency so that no difference remains in their market values for calculating global GDP and comparing the GDPs of different countries. Another factor that needs to be considered while differentiating GDPs is Population. For instance- India has the second largest population in the world. However, India's economy is concise compared to that of the United States, even though its population was around 33 crores in 2021.

Usually, the exchange rates are used to convert one currency into another. The units of currency of country A differ from the currency of country B. For instance- An Australian dollar per US currency, 20 US dollars per British pound, etc. The exchange rates are divided into two categories for comparison - purchasing power parity and currency system or market exchange rates.

The market exchange rate depends upon the international stock values that continuously fluctuate in the supply and demand chain. For the extended measure of exchange rates, the PPP proves to be effective for trying the comparison of GDP between two countries. The US economy is decided on as the basis of calculating GDP per capita because it is the largest compared to others, with $19.485 trillion.

GDP Per Capita = Overall GDP of a Country /Population

Measures to Obtain GDP

1. A country's overall GDP and population units should be the same to evaluate GDP. For example- if the value of GDP is in billions and the population is in a million numerical, divide the GDP by 1000 to get the required units.
2. The total GDP of the country should be divided by the population of the country.

A substantial divide could be seen between the PPP and the market exchange rate due to the growing market and advancing nations. For the growing trade, the average rate of market and PPP is always between 2 and 4. This change in the economy occurs due to the variation in costs as the basic services are cheaper in underdeveloped countries than in developed and progressive ones. There is higher approximated GDP if it is calculated using PPP for developing countries and growing markets.

Real GDP

Inflation plays an important role while measuring the real GDP of a country. The growth in a country's economy based on output can only be measured by considering the inflation of goods. The nominal value (the price of a share or product right after it came out as a byproduct) needs to be modified to notice the drop or rise in prices of manufactured products.

The causes of the rise in prices should also be accounted for to understand if the increase is due to expansion in production or if it is due to the changes in the stock market. The scheme called implicit price deflator is utilized to regulate GDP from nominal to a stable value. Other names for real GDP are Constant-Priced GDP or Inflation-Corrected GDP.

The real GDP is the measure for coordinating the inflation rate of all the commodities and facilities a nation produces in a year. The real GDP is calculated on the groundwork of base-year figures. The base year is the chosen year based on which the prices are compared with the figures of other years. The government uses various GDPs to estimate economic development, such as potential, nominal, and actual GDP. The price deflator measures inflation to view the changes in the price levels of goods and services.

Price Deflator Formula= Nominal GDP/Real GDP×100

The real GDP standards and GDP growth accounted for by the Bureau of Economic Analysis (BEA) are more precise than the accounts of nominal GDP while calculating economic advancement. The real GDP is the ultimate measure of prices as it considers the inflation of goods and uses these prices as constant figures for calculation. After the adjustment of stable prices, compare the amounts of output gained through different goods and between countries' GDPs.

Real GDP measurement is an effective practice in many countries. The countries with higher GDPs, such as the US, also have large amounts of goods and facilities produced each year and maintain their high standard of living. Politicians and policymakers need to strategize their plans if the records suggest that inflation is at its peak or there is a threat of recession and depression in the country in the upcoming future. The nation's citizens prearrange their assets based on the change in the economy and real GDP. If the inflation in price is on the rise, individuals need to make savings, and if all prices are low, they can spend money as they please.

Defects of Real GDP

The real GDP only considers the commodities and facilities available in the market while ignoring many other essential factors.

1. The instruments used for measuring pollution are listed as a part of the GDP record. However, the pollution levels of the countries are overlooked, even though they don't have any major effect on the world economy. If the pollution level rises severely, it highly affects climate change and national frugality.
2. The underground production of illegal resources or resources concealed from the government to stave off sales taxes is not recorded while calculating the real GDP. These productions maintain the balance among the production of goods in the country, and the growth rate remains specific.
3. Another factor that real GDP does not include is the inactivity period. It is an important economic constituent because output production will decrease if the inactivity period is not managed. However, having no leisure to ourselves time can affect the population psychologically and lead to depression among the masses. Therefore, a stable schedule is necessary for finding time for work and ourselves.
   
4. The activities essential for maintaining a standard of life, such as cleaning, cooking, washing, etc., are only included in economic development if market transactions are made for doing these activities. The individuals' time and labor are not recorded as part of GDP if the monetary value is not concerned.

Nominal GDP

In the case of nominal GDP, the present-day market prices are included for measuring a country's GDP. The prices of all goods and facilities are included in calculating nominal GDP except for the inputs used to produce them.

It is another method for measuring the economy's stability within national boundaries. In contrast to real GDP, the figures of nominal GDP do not include the magnitude of inflation or its effects on prices. Nominal GDP is also known as the current dollar.

Methods of Calculating Nominal GDP

There are two ways to estimate nominal GDP.

1. As the nominal GDP does not include the measure of inflation, it can be calculated using the consumption approach of evaluating GDP as mentioned above.

Nominal GDP = C+G+I (X-M)

• C= consumer expenditures
• G= Government investment
• I= Trade Investment
• X= Exports
• M=Imports

2. Another method of calculating nominal GDP is through a price deflator.

Nominal GDP= Real GDP × Implicit Price Deflator

The price deflator is the difference between the GDP of the base year and another year for observing the changes in the meantime.

Impacts of Nominal GDP

The present-day prices are accounted for by measuring the increase in nominal GDP, year to year, and the observation of fluctuation in prices compared to the production of resources. If inflation in the country occurs for all goods altogether, then nominal GDP would magnify along with them. The inflation proves to be a discommodity due to the purchasing power parity decrease for both buyers and shareholders.

The all-inclusive changes in consumer costs based on the basket of goods and facilities in the given period are measured by the Consumer Price Index. It is mostly used to calculate inflation while authorized by the financial market, politicians, and buyers. On the other hand, the standard changes in sales prices received by the product owners for their output in the decided period are known as Producer Price Index (PPI). These two are the general methods used by economists for calculating inflation. Due to the rise in the price scale of the economy, consumers have to spend more to maintain a quality of life. If the earnings and inflation rise simultaneously, the original income of an individual remains stable.

Defects of Nominal GDP

There are many limitations of nominal GDP, and some of them are discussed below:

1. The central banks fail to calculate the nominal GDP and the Inflation target.
2. The Nominal GDP does not include noneconomic factors such as environment, sewage, marginalization, etc., while calculating GDP even though they play a crucial role in the economy.
3. This GDP leaves out certain institutions such as social welfare, volunteering, unpaid apprenticeship, etc., because these facilities do not contribute much to the formation economy and community.
4. Only the price value of the end product after manufacturing is taken into account for measuring nominal GDP, while the production costs or inputs are neglected completely.
5. The rise of recession in the economy due to the price downfall is also known as deflation. Negative GDP growth could be observed if the deflation rate is higher than the yearly production rate, and a negative growth rate affects the economy altogether.

Differences Between Real GDP and Nominal GDP