2.21.

Real GDP versus Nominal GDP

Nominal GDP is the value of all final goods based on the prices existing during the
period of production.
In other words, it is the price that we pay in the market.
Nominal GDP can grow in three ways;
• When output rises and prices remains constant.
• Prices rises and output remains unchanged.
• When both prices and output rises
The problem, then, is how to adjust GDP so that it reflects only changes in output and not
changes in prices.
This adjustment helps us in comparing the GDP over time when prices are changing.
A better measure of economic well-being would tally the economy’s output of goods and
services and would not be influenced by changes in prices.
For this purpose, economists use real GDP, which is the value of goods and services measured
using a constant set of prices.
That is, real GDP shows what would have happened to expenditure on output if quantities had
changed but prices had not.
Real GDP is the value of all final goods produced during a given time period based on the prices
existing in a selected base year. Ethiopia uses 1980/81 prices as the base year.
The value of national output obtained by the use of such base year price is known as Real Gross
Domestic Product (RGDP).
Real GDP is also known as GDP in constant price or Birr. It is GDP adjusted for inflation. The
adjustment factor is known as GDP deflator.
The GDP deflator and consumer price index are indexes measure of change in the general price
level.
GDP deflator is the ratio of nominal GDP to real GDP.
Measuring the Cost of living
Price of a Basket of Goods
One birr today doesn’t buy as much as it did 10 or 5 years ago. The cost of almost everything has
gone up.
This increase in the overall level of prices is called Inflation, and it is one of the primary concerns of
economists and policy makers.
The most commonly used measure of the level of prices is the consumer price index (CPI).
The Statistical Authority has a job of computing the CPI. It begins by collecting the prices of
thousands of goods and services.
Just as GDP turns the quantities of many goods and services in to a single number measuring the
value of production, the CPI turns the prices of many goods and services in to a single index
measuring the overall level of prices.
But how should economists aggregate the many prices in the economy in to a single price index that reliably
measure the price level?
They could simply compute an average of all prices. Yet this approach would treat all goods and services
equally.
Because people might buy more of product X than product Y. Product X should have a greater weight in the
CPI than the price of Y. The statistical authority weights different items by computing the price of a basket of
goods and services purchased by a typical consumer.
The CPI is the price of this basket of goods and services relative to the price of the same basket in some base
year.

CPI = GDP Deflator = Nominal GDP

Real GDP
The consumer price index is the most closely watched index of prices, but it is not the only such
index. Another is the producer price index, which measures the price of a typical basket of
goods bought by firms rather than consumers.
The CPI versus the GDP Deflator
Another measure of price is GDP Deflator that is the implicit price deflator for GDP, which can be
calculated as the ratio of nominal GDP to real GDP.
The GDP deflator is a measure of the general price level.
Where;
QCi = current unit of output or service or item ‘i’. (i = 1, 2, 3 …)
PCi = current price of output or service or item ‘i’ (i = 1, 2, 3 …)
PBi = base year price of output or service or item ‘i’ (i = 1, 2, 3 …)
The GDP Deflator and the CPI give somewhat different information about what’s happening to
the overall level of prices in the economy.
There are three key differences between the two measures;
1st, the GDP deflator measures the prices of all goods and services produced, whereas the CPI
measures the prices of only the goods and services bought by consumers. Thus, an increase in
the price of goods bought by firms or the government will show up in the GDP deflator but not
in the CPI.

2nd, the GDP deflator includes only those goods produced domestically. Imported goods are not
part of GDP and do not show up in the GDP deflator. Hence, an increase in the price of a Toyota
made in Japan and sold in Ethiopia affects the CPI, because consumers buy the Toyota, but it
does not affect the GDP deflator.
The 3rd and most subtle difference results from the way the two measures aggregate the many
prices in the economy.
The CPI assigns fixed weights to the prices of different goods, whereas the GDP deflator assigns
changing weights.
In other words, the CPI is computed using a fixed basket of goods, whereas the GDP deflator
allows the basket of goods to change over time as the composition of GDP changes.
The following example shows how these approaches differ.
Suppose that major frosts destroy the nation’s orange crop. The quantity of oranges produced
falls to zero, and the price of the few oranges that remains on grocers’ shelves is driven sky-
high.
Because oranges are no longer part of GDP, the increase in the price of oranges does not show
up in the GDP deflator.
But because the CPI is computed with a fixed basket of goods that includes oranges, the increase
in the price of oranges causes a substantial rise in the CPI.
The consumer price index is a closely watched measure of inflation.
Policymakers in the Federal Reserve monitor the CPI when choosing monetary policy.
 Many economists believe that CPI tends to overstate inflation the reasons are:
Because the CPI measures the price of a fixed basket of goods, it does not reflect the ability of
consumers to substitute toward goods whose relative prices have fallen.
A second problem is the introduction of new goods.
In effect, the introduction of new goods increases the real value of the dollar. Yet this increase in the
purchasing power of the dollar is not reflected in a lower CPI.
A third problem is unmeasured changes in quality.
Many changes in quality, such as comfort or safety, are hard to measure. If unmeasured quality
improvement (rather than unmeasured quality deterioration) is typical, then the measured CPI rises
faster than it should.
Illustrating Example
Let us take year 1970 as the base year and assume the base year is changed to the year 1990.
So the real GDP is calculated using price of the year 1970 up to 1989
we will use the 1990 price in calculating the real GDP, because year 1990 is selected as base year
for the periods to come after this year.
From this example, we can also see that nominal GDP may change simply because of change in
price level even if there is no change in physical output.
However, real GDP remains unchanged if there is no change in physical output.
For instance, compare both values of real GDP and nominal GDP of the years 1980 and 1985.
Since there was no change in physical output (15 units in both years), there is no change in real
GDP too, which remains 30 million Birr in both years.
 Table 4.Real GDP and Nominal GDP

Unit of goods Nominal GDP (NGDP) Real GDP GDP deflator

andmillions)
services (in Price level (in million Birr) (RGDP) (in (CPI)
Year million Birr)
1970 10 2 20 20 1
1975 12 3 36 24 1.5
1980 15 4 60 30 2
1985 15 6 90 30 3
1988 20 7 140 40 3.5
1990 25 8 200 200 1
1994 30 10 300 240 1.375
1996 30 11 330 240 1.375
1998 32 15 480 256 1.875
1999 34 18 612 272 2.25
2000 35 20 700 280 2.5
 2.2.3. Gross domestic product (GDP) and Gross
national product (GNP)
GDP is the sum of values of all final goods and services produced in the country by citizens of
the country and foreigners.
Therefore, GDP is something related to territory of the country (i.e. GDP is territorial) whereas
GNP is something related to citizenship (i.e. GNP is national).
In other words, whereas GDP measures the total income produced domestically, GNP
measures the total income earned by nationals (residents of a nation).
For instance, if a Japanese resident owns an apartment building in Adama, the rental income
he earns is part of Ethiopia’s GDP because it is earned in the Ethiopia.
However, because this rental income is a factor payment to abroad, it is not part of Ethiopia’s
GNP. It is Japan’s GNP.
The difference between GNP and GDP equals to the net income earned by foreigners (NFP).
The relation between the two values GDP and GNP is given as:
GNP – GDP = NFP
GNP = GDP + NFP
GNP = GDP + Factor payments From Abroad – Factor Payments to Abroad
Here NFP is net factor payment to the citizens, which is the difference between income received
by citizens of the country outside the country and income received by foreigners in the country.
When GDP exceeds GNP, residents of a given country are earning less abroad than foreigners are
earning in that country.
Example: Suppose Ethiopians abroad have produced output worth of 200 million Birr in the year
2017 and at that time, foreigners working in Ethiopia have produced output worth of 150 million
Birr in the same year.
If the Ethiopian GDP in that year is, 800 million Birr, assuming that other things remaining
constant, the net factor payment (NFP) and the GNP are given as follows:

NFP = GNP – GDP NFP = 200 – 150 NFP = 50 million Birr

GNP = GDP + NFP GNP = 800 + 50 GNP = 850 million Birr
Net National product (NNP) or Net Domestic Product
(NDP)

To obtain NNP or NDP, we subtract the depreciation of capital; the amount of the economy’s
stock of plants, equipment, and residential structures that wears out during the year.
In the national income accounts, depreciation is called the consumption of fixed capital.
The only difference between the two is that NDP is calculated from GDP whereas NNP is
calculated from GNP. It can be calculated as;
NDP = GDP – Depreciation
NNP=GNP–Depreciation
For instance, if total output of the country (GDP) in a given year is 100 million USD and the lost
part of capital is goods in generating this national output is 9.5 million US dollar,
then the net domestic product (NDP) of the country in that particular year is given as follows:

NDP = GDP – D = 100 million – 9.5 million USD = 90.5 million USD
National income (NI or Y)
The next adjustment in the national income accounts is for indirect business taxes, such as sales
taxes.
These taxes, place a wedge between the price that consumers pay for a good and the price that
firms receive.
Because firms never receive this tax wedge, it is not part of their income. Once we subtract
indirect business taxes from NNP, we obtain a measure called national income
NI = NNP – Indirect Business Tax
National income measures how much everyone in the economy has earned.
The national income accounts divide national income into five components, depending on the
way the income is earned.
1. Compensation of employees. The wages and fringe benefits earned by workers.
2. Proprietors’ income. The income of non-corporate businesses, such as small farms.
3. Rental income. The income that landlords receive, including the imputed rent that
homeowners “pay’’ to themselves, less expenses, such as depreciation.
4. Corporate profits. The income of corporations after payments to their workers and creditors.
5. Net interest. The interest domestic businesses pay minus the interest they receive, plus
interest earned from foreigners.
Personal Income (PI): is the net value of national income and different personal payments and
receipts.
PI = NI – Social security payments – Corporate income taxes – retained earnings + Dividends +
Transfer payment received + Subsidies + Net interest income
Social security payments are the amount collected from individuals to help the poor, the
disabled and the senior citizens of the country.
A corporate income tax is taxes collected from profit or revenue of corporate organizations
(from organizations not from individuals) by the government.
Retained earnings are part of income generated by corporate organizations and kept in the
organizations for generation of more profit or for strengthening the capacity of the organization
or company.
Transfer payments are amounts of money people receive from their relatives or friends for
free.
Subsidies are amount of money or equivalent amount of other goods and services given by the
government to individuals, companies or organizations to help them.
Interest income is amount of income received on the saved amount of money in the banks.
Disposable income (Yd)

If we subtract personal tax payments and certain nontax payments to the government (such as
parking tickets), we obtain disposable personal income:
Disposable Personal Income (Yd) = Personal Income (PI) − Personal Tax and Nontax Payments.
We are interested in disposable personal income because it is the amount households and
non- corporate businesses have available to spend after satisfying their tax obligations to the
government.
It is the amount that the person is free to spend on whatever he/she likes or to save.
Personal Savings (S)
Personal saving is the amount of disposable income that is left over and above consumption
expenditure.
In other words, personal saving is the difference between disposable income (Yd) and
consumption expenditure (C) and it is given as follows:
S = Yd − C
Where: S is personal saving, C is consumption expenditure, and Yd is disposable income