An economic variable may have both real and nominal values. The nominal value is expressed at current prices and The real value is the value that has been adjusted for the impact of inflation.
Real Value and Nominal Value of GDP
The nominal value is expressed at current prices, Therefore, changes of the nominal value over time reflect the impact of two factors: Changes in the real size of the economic variable and Changes in the general price level (i.e., inflation). The real value is the value that has been adjusted tor the impact of inflation. Therefore, the real value reflects only the real changes in the economic variable. Real value, not nominal value, is more useful in comparing data at different points in time.
Real vs. Nominal GDP
Nominal GDP is GDP measured at current prices. When nominal GDP changes from one year to another, the change reflects the effects of two factors: Changes in actual production and Changes in the price level (i.e., inflation). Real GDP adjusted for the effects of inflation. Real GDP is typically measured relative to the price level in a base year.
GDP Deflator vs. Consumer Price Index (CPI)
Real GDP is computed using nominal GDP and a price index called GDP deflator. GDP deflator reveals the cost of purchasing the items in GDP during a specific period relative to the cost of purchasing these same items during a base year. CPI reveals the cost of purchasing the market basket bought by a typical consumer during a period relative to the cost of purchasing the same market basket during an earlier period.
The GDP deflator is based on a broader basket of goods. The GDP deflator’s basket includes all final goods and services purchased by consumers, businesses, governments and foreigners. The CPI basket only includes goods and services bought by a typical consumer. The GDP deflator allows the basket of goods to change as the composition of GDP changes, while the CPI is computed using a fixed basket of goods. To understand this, suppose that in 20×3 hails destroy all apple trees in the U.S. As a result, no apple is produce in 20×3, and the price of apples remaining in grocery stores rises sharply. The increase in the price of apples will not show up in the GDP deflator, because apples are no longer part of GDP. The increase in price of apples will rise in the CPI because the CPI is computed with a fixed basket of goods that includes apples.
The GDP deflator is used to measure economy-Wide inflation, while the CPI is used to measure inflation in consumer goods.