Write brief notes on the following :

(a)   Real GDP and Nominal GDP.
(b)   Conversion of Nominal GDP into Real GDP. (GDP Deflator).
(c)   Is GDP a correct index of welfare? State its limitations. Explain

(a) Real GDP and Nominal GDP. GDP is broadly sum total of value of goods and services produced within domestic (economic) territory of a country in a particular year. GDP can be measured in two ways — at current prices (prices of the year in which goods and services have been produced) or at constant prices (prices prevailing in the base year).

(i) Nominal GDP. When goods and services included in GDP are valued at current prices, i.e., prices prevailing in the year for which GDP is being measured, it is called nominal GDP. For example, Nominal GDP of 2010 is the value of output produced in 2010 calculated at the market prices prevailing in 2010. In short Nominal GDP values current year's output in an economy at current year prices.

(ii) Real GDP. When GDP is measured at constant (fixed) prices, i.e., prices of the base year, it is called real GDP. Constant prices refer to prices prevailing in some carefully chosen year which is treated as base year. It is a normal year devoid of price fluctuations. In short Real GDP values current year output in an economy at base year prices (i.e., constant prices). Real GDP is the indicator economic welfare. In India presently 2004-2005 is taken as base year for constant prices.

Can Nominal GDP be ever less than Real GDP? Yes, when prices in current year are less than the prices in base year.

Significance of distinction. Real GDP truely reflects the level of economic growth whereas nominal GDP does not. Its reason is that nominal GDP is affected by two factors, namely, change in physical output and change in prices whereas real GDP is affected only by change in physical output. If current market prices rise by 100%, nominal GDP will also rise by 100% even though physical output remains the same. On the contrary, real GDP can change only when physical output changes because prices are fixed or constant. Thus, real GDP is a better and more reliable index of growth of an economy.

(b) Conversion of Nominal GDP into Real GDP. To neutralise the effect of price increases and to know the real change in physical output, Nominal GDP is converted into Real GDP. For this purpose GDP deflator is used. GDP deflator measures the average level of prices of all the goods and services that make up GDP. It is calculated as the ratio of nominal GDP to real GDP multiplied by 100. Algebraically:

For example, if nominal GDP (quantity of goods × current prices) is र 21000 crores and real GDP is र 20000 crores, then:

To eliminate the effect of rise in price, we convert nominal GDP into real GDP with the help of GDP deflator on the basis of above data.

(c) Is GDP a correct Index of Welfare? Often GDP (real GDP) is considered as an index of welfare of the people. Welfare means sense of material well-being among the people. This depends upon availability of goods and services per person for consumption. When GDP (or GNP) rises, it shows increase in flow of goods services. Greater availability of goods and services implies higher standard of living which increases economic welfare. So one may conclude that higher level of GDP is an index of greater well-being of the people. But this may not be correct due to following limitations or reasons.

(i) Distribution of GDP. A mere rise in GDP (or GNP or National Income) may not lead to rise in economic welfare if its distribution results in concentration of income in the hands of very few individuals or firms. A mere increase in GDP does not mean that every individual automatically gets this much of increase. Distribution of GDP might have resulted in making the rich richer and the poor poorer leading to further increase in the gap between rich and poor.

(ii) Non-monetary exchanges or transactions. Many economic activities in the economy are not evaluated in monetary terms. Thus non-market transactions like services of housewife, exchanges through barter, enjoyment from hobbies like painting, gardening, etc. which increase economic welfare are not included in measuring GDP. Hence GDP may not reflect actual productive activities and wellbeing of the country.

(iii)    Externalities. These refer to the benefits or harms which a firm or an individual causes to other in the process of production but for which they are not paid or penalised. For example, negative externalities occur when smoke of a factory pollutes the air or its industrial wastes causes water pollution in the nearby river resulting in loss of social welfare. But nobody is penalised for it nor it is accounted in GDP. GDP does not take into account these externalities. Similarly, positive (beneficial) impact of beautiful garden remains outside of realm of GDP. To that extent GDP is not a correct index of welfare as GDP is then underestimated or overestimated.

(iv)    Composition of GDP. In case increase in GDP is due to more production of war material like tanks, weapons, etc., it will not increase economic welfare.

(v)    Rate of population growth. If rate of population growth is higher than the rate of growth of Real GDP, this will lead to fall in per capita availability of goods and services. This may reduce the overall welfare of the society.

Conclusion. GNP may not be an adequate index due to above-mentioned limitations, yet it does reflect some index of economic welfare. Mere enhancement of GNP at any cost may create economic bads like poverty and pollution. That is why some economists have suggested an alternative measure by the name of Green GNP to widen the scope of GDP as a measure of welfare.

(d) Green GNP. Mind, GNP does not take into consideration the cost in terms of (i) environmental pollution, and (ii) depletion of natural resources caused by production of output. Mere increase in GNP will not reflect improvement in quality of life if it increases environmental pollution or reduces available resources for future generations. That is why concept of Green GNP has been introduced while measuring economic welfare.

Green GNP is defined as "GNP which is indicator of a sustainable use of natural environment and equitable distribution of benefits of development." This concept denotes the following characteristics (i) Sustainable economic development, i.e., development which should not cause environmental degradation (pollution) and depletion of natural resources (ii) Equitable distribution of benefits of its of development. (iii) Promotes economic welfare for a long period of time.

Expressed in the form of an equation :
Green GNP = GNP - Net fall in stock of national capital.