Nominal national income is measured at current market prices. As market prices change, national income changes.
If prices remain constant year after year, then changes in nominal GNP will reflect accurately the underlying changes in production.
But prices rise or inflation occurs. Now national income may go up, even if it does not increase at all over the previous year.
This is due to the rise in prices. We have to eliminate the price change so that the figure does reflect the true measure of economic growth.
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National income, thus, obtained is called real national income or real GNP or GNP at constant prices. The GNP estimated at current (market) prices is called nominal GNP and GNP estimated at constant prices is called real GNP.
Here the term ‘real’ suggests that GNP or GDP data have been adjusted for changes in the level of prices. Suppose, in a particular year, nominal output produced is exactly the same that it produced in the last year. Let us also suppose that prices of all goods have been doubled. Then the money value of all these goods or GDP will double, even though physical output does not change.
In other words, it is possible for nominal GNP in one year to be twice that of nominal GNP in another year. Under the circumstance, GNP or GDP figure does not become reliable indicator of the growth performance of an economy. To correct this situation, economists use the concept of real GDP.
Index number of prices may be used to estimate real GNP. When GNP at current market prices is divided by the price index of base year, we obtain real GNP.
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A calculation has been made in Table 2.2:
GNP at current prices rose from Rs. 400 crore in the year 2000 to Rs. 750 crore in 2008. Meanwhile, price inflation has occurred. As a result, index number of prices rose from 100 to 125. If this price increase is eliminated, national income would increase to Rs. 600 crore in 2008 rather than Rs. 750 crore. Part of the increase in national income at current prices is due to increase in prices and increase in output.
GNP Deflator:
It is clear that nominal GNP usually exceeds real GNP because of inflation. Greater the difference between nominal and real GNP, greater is the inflation. It may happen that GNP data at constant prices may not be available in the economy. If so, a problem of eliminating price change from the nominal GNP will arise. The problem is solved by using GNP deflator.
Comparing price adjusted for 2000 and 2008 GNP figures (Table 2.2), we realize real GNP has increased only to Rs. 600 crore, instead of Rs. 750 crore.