Problem posed by converging nominal and real GDP

  • September 6, 2023
  • Posted by: OptimizeIAS Team
  • Category: DPN Topics
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Problem posed by converging nominal and real GDP

Subject: Economy

Section: National Income

Context: GDP growth rates show interesting  behaviour with both nominal and real terms are almost the same.

Key Points:

  • GDP growth rates show interesting behaviour with both nominal and real terms are almost the same (convergence), at 7.8-8 per cent.
  • This means there is hardly any difference in the growth rates when production is reckoned at current prices and at constant (base 2011-12) prices.
  • Normally the growth in GDP in nominal terms tends to be higher than that of real GDP.
  • What is causing this convergence ?
    • The answer lies in the queer case of inflation in India, where CPI inflation is moving in the positive direction, and the WPI inflation is in negative territory.
    • For every component of nominal GDP there are appropriate price deflators. And in this calculation, the WPI indices are generally used. Hence, if WPI inflation is in the negative zone, which is what it was in Q1, then growth at both constant and current terms would tend to converge.
  • What are the implications of this trend?
    • It is critical from the point of view of targeting fiscal plans as well as external balances.
    • Low nominal growth will come in the way of achieving the target of a $5 trillion economy; the time taken to reach this mark will be more.
    • Revenue receipts on both taxation and disinvestment will be challenged this year. This is so as tax collections are contingent on GDP increasing at a faster tick which provides buoyancy to the system.
    • Care must be taken when interpreting any of the policy ratios such as fiscal deficit to GDP ratio, current account deficitto GDP ratio as the denominator effect can exert undue influence.
    • With the denominator of this ratio, GDP in nominal terms, being lower than was expected the current account deficit is likely to be pushed ahead.
    • With the growth rate now coming down to 6.5 per cent , the denominator effect will automatically raise the fiscal deficit ratio as the GDP will be lower in nominal terms.
    • Further on the fiscal side the debt-to-GDP ratios will also tend to look higher.
Real and Nominal GDP growth

1. Nominal Growth Rate: The nominal growth rate represents the economic growth rate without adjusting for inflation. It is calculated using the current market prices of goods and services. Nominal GDP growth reflects both changes in the quantity of goods and services produced (real growth) and changes in their prices due to inflation.

2. Real Growth Rate: The real growth rate, on the other hand, adjusts for the effects of inflation. It measures the increase in the production of goods and services after removing the impact of rising prices. Real GDP growth reflects changes in the quantity of goods and services produced, holding prices constant.

  • The nominal and real growth rates of an economy can be the same when there is no inflation. In other words, when the inflation rate is zero, nominal and real growth rates will be equal.  When there is no inflation (i.e., the general price level is stable, and prices are not rising), the prices used in calculating nominal GDP remain the same as those used in calculating real GDP.  In this situation:
  • Nominal GDP Growth Rate = Real GDP Growth Rate (since there is no inflation)

However, in most real-world economies, some level of inflation is typically present. In such cases:

  • Nominal GDP Growth Rate > Real GDP Growth Rate (because nominal GDP reflects both quantity and price changes due to inflation).
  • The difference between the nominal and real growth rates represents the inflation rate. So, if you want to calculate the inflation rate when you know the nominal and real growth rates, you can use the following formula:

Inflation Rate = Nominal Growth Rate – Real Growth Rate

Price Deflators

  • Price deflators are economic indicators used to adjust nominal values for inflation, converting them into real values.
  • They are essential for accurately assessing economic growth, comparing economic variables over time, and analysing the impact of policies.
  • Price deflators are constructed using price indices and play a key role in converting nominal GDP into real GDP, providing a more accurate measure of an economy’s actual production levels.
  • The formula for calculating a price deflator is: Price Deflator = (Nominal Value / Real Value) x 100
economy Problem posed by converging nominal and real GDP