2.1.1. Real GDP and Nominal GDP

Nominal GDP refers to current year production of final goods and services valued at current year prices.

Real GDP on the other hand refers to the current year production of goods and services valued at base year prices. Such base year prices are constant prices.

Real GDP is a much better way to calculate the GDP because in a particular year GDP may be bloated up because of high rate of inflation in the economy. Real GDP, therefore, allows us to determine if production increased or decreased, regardless of changes in inflation and purchasing power of the currency.

To explain it better, consider an economy which produces only apples. In a particular year, say

2010, there were 100 apples produced in the economy and the cost of each apple was 1$. The nominal GDP of the economy in 2010 will be 100$ (multiplying 100 by 1$). After 5 years, the production of apples reduced to 50 apples in a year. However, the prices increased to 3$. Then nominal GDP for 2015 will be 150$ (multiplying 50 with 3$). It shows increase in GDP even though production got decreased.

Now consider year 2010 as base year. Then, the real GDP for the year 2010 will be 100$ and for the year 2015 will be 50$ (multiplying 50 with prices of 2010). The decline in real GDP is in proportion to decline in production in the economy. Thus, real GDP represents better picture of any economy than nominal GDP.

The concept of base year has been covered in greater detail in subsequent sections.