Nominal GDP and Real GDP - Essay Example

Running head: Inflation, Nominal GDP and Real GDP Macro Economics Inflation, Nominal GDP and Real GDP Introduction: The government has a role to play in the growth of an economy, policy makers will adjust money supply levels, interest rates and government spending in order to improve on the free market economy. The Phillips curve depict the relationship between unemployment and inflation, when inflation is increased unemployment declines, finally in this paper we discuss nominal GDP and real GDP and the reasons why the GDP level is chained to prices of a previous year. The Phillips curve: The Phillip curve was first coined by William Phillip in 1958, the curve depicts the relationship between inflation and unemployment, according to the Phillips curve unemployment and inflation are inversely related whereby high inflation will result into lower unemployment levels while low inflation results into high unemployment levels, therefore the cost of reducing inflation is unemployment, therefore the curve can be used in decision making whereby policies can be used to increase or reduce inflation in order to adjust unemployment, the following diagram shows the Phillips curve: The chart above demonstrates the Phillips curve, if we assume that the economy unemployment level is at point 0 and that the inflation level is at point x then if inflation increases to point A then the level of unemployment will reduce from point 0 to point 1. if inflation is at point x and inflation is reduced to point B then the level of unemployment will increase from point 0 to 2. Therefore the cost of reducing inflation is increased unemployment. Inflation: Inflation is the persistent rise in price in an economy over a long period of time, there are two forms of inflation which include cost push inflation and demand pull inflation. Demand pull inflation is as a result of increased demand that exceeds the supply level, when demand increases and supply remains constant then price of the good rises and this is what refered to as demand pull inflation. Cost push inflation results from a number of interactions in the economy, this type of inflation is related to wage rates and the increased cost of production which results into an increase in price of goods. In an economy cost push inflation occurs where workers demand for higher wage rates, when wage rates are increased the cost of production increases. When the cost of production increases then the price of goods increase leading to inflation. When the price of goods increase consumers who are the workers experience a reduction in their real income and therefore demand for higher pay and the cycle continues, however there are other factors that may lead to inflation example increased money supply, increased government expenditure and reduced borrowing rates, inflation can therefore be reduced by reducing government expenditure, reducing money supply and increasing borrowing rates or interest rates. Long run and the short run Phillips curve: Due to rational expectations in the economy the short run and long run Phillips curve differ, the long run Phillips curve is drawn as a vertical line, this concept is due to the natural rate of unemployment that prevails in the economy, when individuals in the economy rational expectations that inflation will increase then the inflation level will be higher than the expected inflation level, diagram below shows the long run and the short run Phillips curve. The chart above shows the long run and short run Phillips curves, if the economy starts at short run Phillips curve 1 and individuals in the economy have rational expectations that inflation will rise, then inflation will rise but the rational expectations will increase inflation to higher level at the same unemployment level and this will lead to a shift in the short run Phillips curve to short run Phillips curve 2, the point market b on the above diagram shows the non accelerated rate of unemployment which is referred to as NAIRU. Therefore in the long run the long run Phillips curve will be a vertical line shown in the above diagram. GDP and GNP: Gross domestic production is the total value of goods and services that are produced in a country in a specific year; the gross net production is the total value of goods and services that are produced in a country in a specific year minus net foreign income. These measures are important in that they are used in determining economic growth of a country, these measures are also important in that they are used in comparing the same economy between two periods and also comparing between countries. Gross domestic production can be measured using two methods which include the expenditure method whereby all expenditures on final goods are added up, the income method where all the income to all the factors of production are determined and added up. The expenditure method depicts that GDP = consumption + investment + government expenditure + exports - imports. The income method depict that GDP = employee compensation + operating surplus + mixed income + taxes - subsidies. In measuring gross domestic production some problems occur example black market goods on whether to include or exclude them, the quality of goods when comparing the GDP of two countries, subsistence production which may lead to underestimation of GDP and finally how to record gifts and voluntary work. The US measured its national income and economic activities using gross national production until 1992 where it switched to gross domestic production for various reasons, on of the main reasons why this was done in order to make US accounts to be consistent with those of other nations, the other reason was because GDP is a measure of domestic production whereby both domestic and foreign production are included unlike in the case of GNP. Finally GNP added up national income ignoring the fact that production may have been undertaken by non residents. Real and nominal GDP: Nominal GDP is a measure of GDP using the same year prices, Real GDP on the other hand is the measure of GDP using a different year prices. Therefore real GDP takes into consideration the inflation rate that prevail in the economy, for example if the same volume of goods and services were produced in two consecutive years and there has been an increase in prices from the previous year, then the value of nominal GDP will be higher in the second year than in the previous year due to price changes. Example: If in an economy there are only two goods produced which include cars and food, we take three years which is 2005, 2006 and 2007. The price of these goods is summarized below: car price food price 2005 100 50 2006 110 60 2007 130 80 The production level is summarized below: car volume food volume 2005 1000 2000 2006 1000 2000 2007 1500 3000 The nominal GDP and Real GDP are summarized in the table below: nominal GDP real GDP chained to 2005 dollar 2005 200000 200000 2006 230000 200000 2007 435000 300000 From the above table it is evident that nominal GDP has increased over the years, also real GDP remained constant in year 2005 and 2006 and increased in 2007, therefore real GDP takes into consideration the inflation level in the economy. Why use real GDP and benefits: One of the reasons why we chain GDP and GNP is because by chaining we get the real GDP or GNP level, as discussed above real GDP takes into consideration the prevailing inflation in the economy, as a result of this the real GDP level will provide us with a more accurate picture of economic growth, from the above example of an economy that produces cars and food it is evident that nominal GDP depict that there has been economic growth from the year 2005 to 2006 where in 2005 nominal GDP was 200000 while in 2006 the nominal GDP level was 230000, however from the number of products produced both years produced same units of cars and food and therefore there was no growth, the real GDP therefore provides a clear picture of economic growth because in the example both years show that the real GDP level for 2005 and 2006 are equal. Conclusion: Inflation according to the Phillips curve is inversely related to unemployment, when inflation in an economy increases unemployment declines and as inflation declines unemployment increases. The long run Phillips curve is a vertical curve which depicts the role of rational expectations in the economy. Government policies affect the prevailing inflation rate in the economy and therefore the government will reduce unemployment by increasing inflation. When measuring the level of GDP there is a need to take into consideration the changes in price levels which may affect production in an economy, for this reason therefore real GDP and GNP level should be used instead of nominal values, the benefits of using chained values is because inflation is taken into consideration given that government policies and other factors will affect then price levels in the economy. As a result of this the real GDP is used in order to take into consideration inflation and price changes that have occurred over the years. However there is need for more research on issues concerning the relationship between prevailing prices and the GDP levels in an economy, it is more likely that when price increases the GDP level will also increases, this is due to the fact that inflation leads to increased employment and therefore increased output. References: Foley K and Sidrauski M (1991) Monetary and Fiscal Policy in a Growing Economy, Macmillan publishers, New York Gregory Mankiw (2001) Principles of Microeconomics, Prentice Hall publishers, New Jersey Lerner P. (1992) Economics of Employment, McGraw Hill Press, New York Phillip Hardwick (2002) introduction to modern economics, McGraw Hill publishers, New York Read More