Real and Nominal GDP and GNP

Valuing a collection of goods and services in monetary terms gets around the problem of adding apples and oranges but poses another problem. Which market prices should be used? Market prices vary over time and a given collection of goods and services would have significantly different value at two different points to time. A deceptively simple answer to this question would be user prices prevailing at the time valuation is done. Recall that GDP and GNP are used as a measure of economic activity. As we will discuss further, per capita GDP is widely used as a measure of living standards. Obviously this would be justified if these concepts measure in some sense the physical volume of goods and services available in an economy. Money provides a convenient unit of account so that apples and oranges can be added up. However monetary valuations can be quite misleading. Consider a firm that manufactures and markets apple jam and mango pickle. Suppose during 2001 it produced 5 lakh kilograms of apple jam and 3 lakh kilograms or mango pickle. At market prices of Rs 95 per kilogram of apple jam and Rs 60 per kilogram of mango pickle the rupee value of its output was Rs 6.55 crores. During 2002, the apple crop in some parts of the country was affected by bad weather and the company could produce only 4 lakh kilogram of apple jam and 3 lakh kilogram of mango pickle. However, the price of apple jam had shot up to Rs 125 per kilo while the price of mango pickle had gone up to Rs 63. The value of output of the firm in 2002 measured witn 2002 prices thus increased to Rs 6.89 crores, apparently an increase of a little over 5% when the physical quantum of production had actually gone down. If 2001 prices are used, the value would have been Rs 5.60 crores. While the nominal output went up real output declined. What is true of a firm is true of an economy. We must find some way of separating the change in physical quantum of production from the change in monetary value which can be attributed only to changes in prices. National income statisticians solve this problem by using two different sets of prices to do the valuation. The nominal GDP or GDP at current prices for a particular year is measured using that year’s process; real or constant price GDP is measured using a fixed set of prices usually the prices ruling in a specified base year. Obviously, the choice of the base year is discretionary. In practice, it is updated every ten years or so. To assess the performance of the economy it is the real GDP that matters.

Rich and Poor Nations:

The World Bank classifies countries into: Low income, Middle income and High income. The low income countries are often referred to as the Third World. The question we face is how do we measure richness of a country?

The accepted measure of standard of living of a nation is per Capita GDP. It is simply GDP divided by the population. By this measure the world Bank reported Ethiopia to be the poorest country with per capita GDP of $100 per annum in 1996 and Switzerland to be the richest with $44350. For the year 1998-99 India’s per capita NNP was reported to be nearly Rs 15000 which would have translated into approximately 360 dollars. Can one say that a typical Swiss citizen is about 150 times as well as an average Indian?

While understanding this, two caveats should be kept in mind.

1. Inter-country comparisons of per capital GDP measured in a common currency can be quite misleading.
2. Market exchange rates do to reflect the differences in purchasing powers of different currencies in their own countries.

For example a haircut in New York might cost 15-20 dollars were as the price of a haircut in Mumbai converted into dollars at the market exchange rate would be no more than a dollar or two. One needs a correction to take account of these relative price differences. The correction is unlikely to change the relative ranking of countries but will correct extreme distortions which the raw figures tend to project. Also, it has been argued quite convincingly that a higher per capita GDP need not imply a higher quality of life.

Over time changes in living standards are captured by changes in per capita real GDP. This is obtained by subtracting the population growth rate from the growth rate in real GDP.