One implicit assumption in all the discussion around ‘National Income Accounting‘ is that the prices of goods and services do not change. If prices change, then there may be difficulties in comparing GDPs.
If we measure the GDP of a country in two consecutive years and see that the figure for GDP of the latter year is twice that of the previous year, we may conclude that the volume of production of the country has doubled. But it is possible that only prices of all goods and services have doubled between the two years whereas the production has remained constant.
Therefore, in order to compare the GDP figures (and other macroeconomic variables) of different countries or to compare the GDP figures of the same country at different points of time, we cannot rely on GDPs evaluated at current market prices. For comparison we take the help of real GDP.
Real GDP is calculated in a way such that the goods and services are evaluated at some constant set of prices (or constant prices). Since these prices remain fixed, if the Real GDP changes we can be sure that it is the volume of production which is undergoing changes.
Nominal GDP, on the other hand, is simply the value of GDP at the current prevailing prices.
For example, suppose a country only produces bread. In the year 2000 it had produced 100 units of bread, price was Rs 10 per bread. GDP at current price was Rs 1,000. In 2001 the same country produced 110 units of bread at price Rs 15 per bread. Therefore nominal GDP in 2001 was Rs 1,650 (=110 × Rs 15). Real GDP in 2001 calculated at the price of the year 2000 (2000 will be called the base year) will be 110 × Rs 10 = Rs 1,100.
Notice that the ratio of nominal GDP to real GDP gives us an idea of how the prices have moved from the base year (the year whose prices are being used to calculate the real GDP) to the current year. In the calculation of real and nominal GDP of the current year, the volume of production is fixed. Therefore, if these measures differ it is only due to change in the price level between the base year and the current year. The ratio of nominal to real GDP is a well-known index of prices. This is called GDP Deflator.
Thus if GDP stands for nominal GDP and gdp stands for real GDP then,
GDP deflator = GDP / gdp
Sometimes the deflator is also denoted in percentage terms. In such a case
GDP deflator = (GDP / gdp) × 100 percent
In the previous example, the GDP deflator is 1,650 / 1,100 = 1.50 (in percentage terms this is 150 per cent). This implies that the price of bread produced in 2001 was 1.5 times the price in 2000. Which is true because price of bread has indeed gone up from Rs 10 to Rs 15. Like GDP deflator, we can have GNP deflator as well.
There is another way to measure change of prices in an economy which is known as the Consumer Price Index (CPI). This is the index of prices of a given basket of commodities which are bought by the representative consumer. CPI is generally expressed in percentage terms. We have two years under consideration – one is the base year, the other is the current year. We calculate the cost of purchase of a given basket of commodities in the base year. We also calculate the cost of purchase of the same basket in the current year. Then we express the latter as a percentage of the former. This gives us the Consumer Price Index of the current year vis-a-vis the base year.
For example let us take an economy which produces two goods, rice and cloth. A representative consumer buys 90 kg of rice and 5 pieces of cloth in a year. Suppose in the year 2000 the price of a kg of rice was Rs 10 and a piece of cloth was Rs 100. So the consumer had to spend a total sum of Rs 10 × 90 = Rs 900 on rice in 2000. Similarly, she spent Rs 100 × 5 = Rs 500 per year on cloth. Summation of the two items is, Rs 900 + Rs 500 = Rs 1,400.
Now suppose the prices of a kg of rice and a piece of cloth has gone up to Rs 15 and Rs 120 in the year 2005. To buy the same quantity of rice and clothes the representative will have to spend Rs 1,350 and Rs 600 respectively (calculated in a similar way as before). Their sum will be, Rs 1,350 + Rs 600 = Rs 1,950.
The CPI therefore will be (1,950 / 1,400) × 100 = 139.29 (approximately).
It is worth noting that many commodities have two sets of prices. One is the retail price which the consumer actually pays. The other is the wholesale price, the price at which goods are traded in bulk. These two may differ in value because of the margin kept by traders. Goods which are traded in bulk (such as raw materials or semi-finished goods) are not purchased by ordinary consumers. Like CPI, the index for wholesale prices is called Wholesale Price Index (WPI). In countries like USA it is referred to as Producer Price Index (PPI).
Notice CPI (and analogously WPI) may differ from GDP deflator because –
- The goods purchased by consumers do not represent all the goods which are produced in a country. GDP deflator takes into account all such goods and services.
- CPI includes prices of goods consumed by the representative consumer, hence it includes prices of imported goods. GDP deflator does not include prices of imported goods.
- The weights are constant in CPI – but they differ according to production level of each good in GDP deflator.
Bibliography : NCERT – Introductory Macroeconomics