GDP and Inflation

In this post we will discuss about two very important economic terms, GDP and Inflation. These are the two most commonly used terms if you open any business newspaper or news channel. We will try to understand from a layman’s perspective what they mean and how both impact us.

Let’s get started!

GDP

GDP or Gross Domestic Product is gross total market value of all goods and services produced within boundaries of a country in a specific year (or period). Goods and services include anything and everything that we produce within the country. For example, houses, vehicles, clothes, dairy products, farming products, IT services etc. GDP represents the monetary value of a country’s economy.

Let’s consider a country X which only produces pencils –

YearPrice per pencilNumber of pencilsGDP
1Rs.10100Rs.1000
2Rs.10.5105Rs.1102
3Rs.11110Rs.1210

In year 1, total 100 pencils are produced priced at Rs.10 each, hence the GDP is Rs.10 x 100 = Rs.1000. Similarly GDP is calculated for year 2 and year 3 as well.

Inflation

Inflation is a rate at which the prices of goods and services increase in a country. Due to inflation, same amount of money is able to buy lesser goods and services over a period of time which means that purchasing power of currency decreases. A classic example is the approximate prices of Amul butter (500 gm) in India which used to be Rs.6.50 in 1970s, while costs Rs.180 in 2019!

Inflation can occur due to two reasons –

  • If overall demand of goods and services go up but the production is not enough to fulfill the demand, naturally the prices will go up. For example, if everyone started buying houses in same locality and availability is limited, the housing prices within that locality go up.
  • If the cost of producing goods and services rises, for example, the raw material may become expensive or the workers’ wages may increase, these factors will result in a higher production cost and final prices will increase.

Let’s talk about our country X –

YearPrice per pencilPrice RiseInflation
1Rs.10--
2Rs.10.5Rs.0.55%
3Rs.11Rs.0.54.8%

Price per pencil goes up by Rs.0.5 in year 2 and year 3 by inflation rate of 5% and 4.8% respectively. This means that you could buy a pencil for Rs.10 in year 1, but you won’t be able to buy the same pencil in year 2 and year 3 if you only had Rs.10.

Nominal GDP

Now since we understand GDP and Inflation, let’s move to another key term i.e. Nominal GDP. By now we know that overall market value of all goods produced in a country in a year is that year’s GDP, but we also observed that prices of these goods will go up year on year. This price rise will also contribute to the overall GDP.

Let’s go back to our example of country X –

YearPrice per pencilNumber of pencilsTotal price riseInflationNominal GDPNominal GDP Growth Rate
1Rs.10100--Rs.1000-
2Rs.10.5105Rs.52.55%Rs.110210.2%
3Rs.11110Rs.554.8%Rs.12109.8%
4Rs.11.5110Rs.554.5%Rs.12654.5%

If we observe year 3 and 4 carefully, the number of pencils produced remains the same i.e. 110 but the price per pencil goes up by Rs.0.5 in year 4. This results in GDP of Rs.1265 in year 4 as compared to Rs.1210 in year 3. The production remains the same, but the GDP goes up simply because each pencil is more expensive now.

In simple words, if the GDP factors in the increased prices of goods i.e. inflation, it is termed as Nominal GDP. A growing Nominal GDP may not always mean good, as it may be growing due to inflation not due to actual production.

Real GDP

If the GDP does not factor in inflation and accounts only for absolute production, it is referred to as Real GDP.

Continuing with the example of country X –

YearPrice per pencilNumber of pencilsInflationNominal GDPNominal GDP Growth RateReal GDPReal GDP Growth Rate
1Rs.10100-Rs.1000-Rs.1000-
2Rs.10.51055%Rs.110210.2%Rs.10505%
3Rs.111104.8%Rs.12109.8%Rs.11004.8%
4Rs.11.51104.5%Rs.12654.5%Rs.11000%

We can see that Real GDP is always lower than Nominal GDP as it only factors absolute production and doesn’t factor the increased prices of pencils. If we observe the number of pencils produced in year 4, it is same as year 3 and hence the Real GDP is same for both years and the Real GDP growth rate is zero!

An increasing Real GDP can be attributed to overall growth of country as the absolute production of overall goods and services is increasing.

Why you should understand Inflation and GDP ?

Inflation is precisely the reason why savings bank accounts pay an interest of 3-4% on deposits. The money in savings account does not grow, in fact it’s purchasing power decreases with time. Banks just pay an interest equal to inflation to keep that purchasing power intact.

Let’s talk about how inflation affects investments. If your investments earn 7% over a period and inflation rises by 4% in same period, your effective returns are 3%. Do you think 3% returns are enough to achieve your long term goals?

Since inflation causes the overall prices of goods and services to go up, it is very important factor to be considered while investing. Our investments should be comfortably able to beat inflation over a long period to earn actual returns.

Lastly, a higher real GDP is always achievable in a developing country in an ideal scenario. Simplest reason being, there will be many consumers in a developing country who are yet to buy basic goods and services like houses, vehicles etc. In simple words, there is still lot of basic demand that needs to be catered for which goods would have to be produced and hence the Real GDP must grow. The best investment that one can make is in this country’s economy or Real GDP itself , the investment grows along with the economy!

Wrap-up

Take a moment and think about it, would your investments be able to beat inflation? Are you investing in a developing economy?

Your feedback, comments and questions are most welcome!

*Disclaimer – The definitions and numbers used in this post are for simplistic representation purposes only and may not be 100% complete and accurate technically.