Real versus Nominal GDP

Nominal GDP is the money value of all the goods and services produced in a year. Nominal GDP is calculated at the current market prices. However, Nominal GDP does not truly indicate the real performance of the economy as the prices changes over time.

Back to Basics: Suppose, India as a country only produced cars in its economy. In the year 2016, India produced 100 Cars which were sold at RS 100,000 each. India’s GDP in this case will be RS 10,00,00,00 (100*100000).

In the year 2017, supposedly due to demonetization India only produced only 90 Cars, but their price has risen to RS 15,0000. India’s GDP in the year 2017 will be 1,35,00,000.

The Increase from RS 10,00,00,00 to RS 1,35,00,000 is the nominal GDP. The GDP of India has risen not because we have produce more units of Car but because the prices of the car have increased.

Therefore, the Nominal GDP does not capture the changes in the real economy.

Real GDP

The real GDP is calculated as the money value of all the goods and services produced in a year using the constant set of market prices that have prevailed in the certain chosen base year. The Real GDP is calculated at a fixed set of prices so that only the changes in real output or real production of goods and services is captured.

Back to Basics: Suppose, India as a country only produced cars in its economy. In the year 2016, India produced 100 Cars which were sold at RS 100,000 each. India’s GDP in this case will be RS 10,00,00,00 (100*100000).

In the year 2017, supposedly due to demonetization India only produced only 90 Cars. If we take the year 2011-12 as the base year and assumes that the price of the car in that year was RS 90,000. Then, India’s Real GDP will be 90*90,000= 81,00,000.

The Nominal GDP is RS 1,35,00,000 whereas the Real GDP is RS 81,00,000. The difference is due to the prices which have risen from 90,000 in the base year to RS 15,00,00 in the current year.

Limitations of the Concept of GDP/Economic Growth

Note for Students: The following examples will make it clear why GDP is not a perfect measure of Well Being.

• Suppose, due to unemployment in the economy the youth drifts towards Crime. To overcome the crime rate, the government decides to hire more police personnel. Due to the hiring of police personnel, the economic activity in the economy increased as the newly employed personnel will be paid salaries, which they will spend on purchasing goods and services. Hence Production of Goods and services will increase. The final outcome is increase in the GDP.

Now tell me is this increase in the GDP is worth considering? The GDP has risen due to wrong reason, i.e., increase in crime.

In the above case, the GDP fails to capture the deteriorating situation of the society.

• Suppose, the Government of India decides to mine resources from the fragile Western Ghats. The mining of the resource leads to the production of resources which are used in the production of goods and services. The increased production will lead to increase in the GDP.                                 But, due to mining activity, the population near the Ghats were disposed of or removed. At the same time, the mining activity has made the region prone to flooding. The floods in the coming year will destroy valuable life and property. The loss due to dispossession and flooding will not be captured in the calculation of the GDP. Thus, in this case also GDP has risen but at the cost of negative externality in the form of loss of livelihood and lives.

Economic Growth versus Economic Development

The two-argument provided above are also valid for the shortcomings of growth.

Economic Growth is a monetary concept. It only takes into account the value of goods and services produced in the economy. It tells how much a country has progressed in terms of economic indicators like GDP, Per Capita Income, Production, employments etc. It measures only quantifiable outcomes.

Let’s Understand Growth

The First Stage:

The story so far is very impressive a business-friendly government with pro-business policy increased growth and employment.

The Second Stage:

The Third Stage

The Fourth and Final stage: The Crisis

The above model is just an easy explanation of a complex system. Is it really the pro-business policies of the government that have led to the crisis?

The answer is no. It is the lack of balanced policy or a single point focus on the growth that has led to the crisis.

What has the Government missed in the process?

• If at the very beginning, along with pro-business policies, the government had adopted the policies to promote education, skill development, research and innovation, health and social empowerment, the outcome could have been very different. A progressive education and health sector along with technological advancement would have taken care of skilled and educated labour needed in the production processes.

The First lesson, therefore, is “Along with the policies to promote Physical Capital the government must promote the policies of Human Capital”. Therefore, the first difference, “Promotion of Physical Capital is a growth oriented measure, but promoting the Human capital along with Physical Capital is a development oriented measure”.

• In the above setup, the government had adopted a policy of excessive deregulation of the economy. The problem with excessive deregulation is that it does more harm than good. If the government have moved cautiously with the deregulation, it could have avoided the crisis.

If for example, when the first stage boom had happened, the government should have adopted the policy of promoting new firms by encouraging competition, by providing the new firms with opportunities in the form of lower taxes, interest-free capital. Instead, the government followed the existence firms demand of more rebates, more deregulation which created a monopoly like the situation with restricting enter. The new firms would have competed with the older firms, and in the process, the poor performing firms would have thrown out of the market, and the best surviving firms could have produced efficiently and at a much lower price.

The second lesson, therefore, is “The role of government is to promote competition and healthy environment for the firms to operate and not to practice Crony Capitalism in nexus with old firms”. Therefore, the policy of excessive deregulation along with creating a monopoly kind structure is a growth oriented move, but promoting and encouraging new firms through fair competition is a development oriented measure”.

• The government promoted a policy of Land reforms which favoured firms and Businesses. Instead, the government must have come up with a policy which could have taken care of the poor and farmers. The government should have provided land at the fair market price along with the provision of forcing firms to undertake developmental activities like promoting primary health centres, secondary schools and another social sector initiative like computer training and skilling of rural youth who have lost their lands. This could have fastened the land reform process and makes it more acceptable to poor.

The Third lesson, therefore, is “A balanced approach towards resource redistribution does more good as compare to a one-sided measure of promoting business welfare”. The governments must force the firms to provide essential services in the areas of the land takeover. Therefore, land acquisition along with welfare of the region is a development measure.

• The last point is with respect to labour reforms. The flexibility of the labour market is the need of the hour. But it should be done keeping in mind the welfare of the labour. The government must do labour reforms which promote healthy employment along with bringing the labour in the social security net. The opening up of labour markets by killing unions and bargaining power of labour will only lead to labour exploitation and labour unrest and business loss. A better approach is to make labour market flexible for both employer and employee so that they can move out easily from one job to another. This can be done through proper contracts, well-functioning legal system, working social security net for labourers and skilling and training of labourers.

Therefore, the fourth lesson “Labour Market reforms carried with the welfare of the labour is a development oriented measure”.

The story in a nutshell, therefore, is “Growth is only a necessary condition and not a sufficient condition for promotion of well-being and raising the standard of living of the people”.