Why do we have to do this distinction between nominal and real GDP? The answer is that real GDP is much more accurate metric in terms of measuring a country’s material wellbeing than that of nominal GDP (NGDP) because real GDP (RGDP) is adjusted for inflation or deflation.
In other words, real GDP refers to domestic production of final goods and services valued at constant prices whereas nominal GDP means domestic production of final goods and services valued at current prices.
Imagine an economy that produces only two types of dates, Ajwa and Anbara dates, nothing else.
Let’s call this country Dateland. And assume that Dateland uses Saudi Riyal (SAR) as its currency. Dateland Statistical Agency (DSA) publishes the historical data for production and prices shown in Table 1:
| Year | Price of Ajwa (per kilogram) | Quantity of Ajwa dates (In kilograms) | Price of Anbara (per kilogram) | Quantity of Anbara dates (In kilograms) |
| 2019 | 8 SAR | 900 | 3 SAR | 3 SAR |
| 2020 | 4 SAR | 1,200 | 5 SAR | 1,100 |
| 2021 | 6 SAR | 1,000 | 5 SAR | 1500 |
From the data in Table 1 we can easily calculate nominal GDP of Dateland at a given year by
multiplying the market price of each type of date with its quantity and then adding them together shown in Table 2:
Table 2
| Year | Calculation | Nominal GDP |
| 2019 | 8 SAR x 900 kg Ajwa dates + 3 SAR x 1,200 kg Anbara dates | = SAR 10,800 |
| 2020 | 4 SAR x 1,200 kg Ajwa dates + 5 SAR x 1,100 kg Anbara dates | = SAR 10,300 |
| 2021 | 6 SAR x 1,000 kg Ajwa dates + 5 SAR x 1,500 kg Anbara dates | = SAR 13,500 |
To calculate the real GDP, we need to choose a base year.
The base year should be a representative year in that the country in that year must not experience any abnormal occurrences such as famines, floods, devastating earthquakes, disruptive political upheavals, major economic downturns and so on – no calamity year is the base year.
Let’s assume that 2020 is one of those representative years in Dateland’s short economic history. Hence, we take 2020 as the base year for Dateland. Now using 2020 prices of Ajwa and Anbara dates, we can calculate real GDP of Dateland for the years 2019, 2020, and 2021 as shown in Table 3.
| Year | Calculation | Real GDP |
| 2019 | 4 SAR x 900 kg Ajwa dates + 5 SAR x 1,200 kg Anbara dates | SAR 9,600 |
| 2020 | 4 SAR x 1,200 kg Ajwa dates + 5 SAR x 1,100 kg Anbara dates | SAR 10,300 |
| 2021 | 4 SAR x 1,000 kg Ajwa dates + 5 SAR x 1,500 kg Anbara dates | SAR 11,500 |
It is not a surprise that in 2020, which is the base year, the nominal GDP of Dateland is equal to its real GDP.Lesson learned – the base year’s real GDP is always equal to its nominal GDP. Furthermore, in nominal terms 2019 seems a better year than that of 2020 (NGDP of SAR 10,800 in 2019 versus NGDP of SAR 10,300 in 2020) but not in real terms (RGDP of SAR 9,600 in 2019 versus RGDP of SAR 10,300 in 2020).
If we assume that people’s material wellbeing is the only factor that makes them happy (a very strong assumption!), then we can argue that in 2020 Dateland people were much happier than 2020 because the real GDP of the country in 2020 was higher than that of 2019.
However, among these three years, the happiest year for Dateland citizens was 2021 because in that year Dateland generated the highest real GDP (Table 3).
However, we should still be very watchful about media’s use of the word GDP because usually it is impossible to distinguish whether the author means real or nominal GDP.
One of the ways for capturing inflating (or deflating) effects of prices on GDP is to calculate GDP deflator for each year
using the following formula:
GDP deflator is a metric of the average (or aggregate or general) price level calculated as the ratio of nominal GDP to real GDP multiplied by 100.
| Year | Nominal GDP | Real GDP | GDP Deflator |
| 2019 | SAR 10,800 | SAR 9,600 | |
| 2020 | SAR 10,300 | SAR 10,300 | |
| 2021 | SAR 13,500 | SAR 11,500 |
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