The main difference between nominal and real values is that real values are adjusted for inflation, while nominal values are not. As a result, nominal GDP will often appear higher than real GDP.
Nominal values of GDP (or other income measures) from different time periods can differ due to changes in quantities of goods and services and/or changes in general price levels. As a result, taking price levels (or inflation) into account is necessary when determining if we are really better or worse off when making comparisons between different time periods. Values for real GDP are adjusted for differences in prices levels, while figures for nominal GDP are not.
The GDP Deflator
The GDP deflator is an economic metric that converts output measured at current prices into constant-dollar GDP. This includes prices for business and government goods and services, as well as those purchased by consumers. This calculation shows how much a change in the base year's GDP relies upon changes in the price level.
If we wish to analyze the impact of price changes throughout an economy, then the GDP deflator is the preferred price index. This is because it does not focus on a fixed basket of goods and services and automatically reflects changes in consumption patterns and/or the introduction of new goods and services.
Real GDP for a given year, in relation to a "base" year, is computed by multiplying the nominal GDP for a given year by the ratio of the GDP price deflator in the base year to the GDP price deflator for the given year.
Suppose we wish to calculate the real GDP for the year 2001 in terms of 1996 dollars. The value for (note that these values are for illustration purposes only) 1996 price deflator is 100 and the 2001 price deflator is 115. The 2001 GDP in nominal terms is $10 trillion dollars.
Then: Real GDP year 2001 in 1996 dollars =$10 trillion × (100 / 115) = $8.6 trillion
Limitations of GDP and Alternative Measures
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