What is Real Gross Domestic Product (GDP)?

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Definition:

Real Gross Domestic Product (real GDP) is a macroeconomic indicator of how much value an economy is creating, after accounting for inflation.

🤔 Understanding real gross domestic product

Real Gross Domestic Product (real GDP) is the value of all the goods and services created within an economy during a given timeframe (typically one year), adjusted for inflation (the tendency for prices to increase over time). The inflation adjustment is important when trying to understand if an economy is really improving, or if it just looks like it’s growing because of price changes. GDP is a measure of how much value an economy is creating. In general, GDP points to how many people are gainfully employed and how much money they are making. An improving GDP implies people's lives are improving. However, if GDP increases solely because of inflation, it might not result in more jobs or any improvement in the standard of living.

Example

In 2008, the GDP of the United States was $14.713T. That was an increase from the $14.452T in 2007. On the surface, it appears that the U.S. economy grew by 1.8% between 2007 and 2008. However, that does not quite mean what it appears. After adjusting for the 2.8% inflation that occurred over the same period, we can see that the U.S. economy did not grow in real terms. Looking at the real GDP reveals that the economy actually shrunk by $21B between 2007 and 2008 in inflation-adjusted dollars.

Takeaway

Real GDP is like taking your shoes off to measure your weight…

When you go to your annual physical, the nurse will probably take your weight. It’s important to understand how things have changed since your last visit. But, if you were wearing winter boots on one visit and sandals on another, the change in your reading might not have anything to do with your diet, exercise, or health. By taking off your shoes (adjusting for inflation), you get a better sense of how your weight (economic output) has truly changed over time.

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What is the difference between real GDP and nominal GDP?

Gross domestic product (GDP) measures the economic output of a country. It counts up the value of all goods that people buy from businesses within a country during a year and subtracts things purchased from other countries. It also accounts for government spending and investments by companies on new equipment.

In economics, nominal values are ones that have not been adjusted for inflation (the tendency for prices to rise over time). When something is called a real value, it means that inflation has been accounted for. Therefore, nominal GDP is the data as it was collected. Real GDP has been adjusted for inflation.

What is real GDP used for?

Real gross domestic product (GDP) is a better measure of how an economy is changing than nominal GDP. Without accounting for inflation, a GDP number might increase only because of inflation. That might give the impression that economic growth is occurring. But it is a false sense of accomplishment. An economy that is only growing because due to inflation is not actually growing — The same things just cost more. It is not truly increasing the wealth of the citizens.

For this reason, government officials need to understand the true state of the economy in order to implement the correct policies. For example, Congress might want to jumpstart the economy with stimulus spending if it is slumping. Or, it might want to increase taxes to slow the economy down if it is growing at unsustainable levels. These actions are called fiscal policy.

Likewise, the Federal Reserve may want to help loosen up credit markets when the economy stumbles. By decreasing the interest rate, it can encourage more lending and borrowing to occur. When the Federal Reserve makes changes to alter the state of the economy, it is called monetary policy.

Without accounting for the effects of inflation, both fiscal and monetary policies can become less effective. Most often, the error comes from assuming that nominal growth in GDP suggests economic strength. However, it is possible for nominal GDP to be positive, while real GDP growth is negative. Or, in the case of deflation (negative inflation), the change in nominal GDP could be negative, while real GDP is positive. In that circumstance, the economy might be in need of assistance, but that need is masked by a change in the price level.

How do you calculate real GDP?

A country’s gross domestic product (GDP) is the value of its production. Nominal gross domestic product is the sum of all of the things created inside the country’s borders, during a certain time period, using current prices. The simple formula for GDP is:

GDP = C + G + I + X

The “C” stands for household consumption. It includes all of the things that households purchase from businesses within the country. It does not count intermediate goods (the materials a business uses to make another product). For example, flour counts if a household buys it for their kitchen, but not if a business buys it to make bread that it then sells. If it was counted, that flour would be counted twice, once as flour and again as part of the price of the bread. This measure also removes the value of any intermediate goods purchased from another country.

The “G” is for government spending. It is mostly the payment of wages to public employees, but also includes some depreciation and other accounting adjustments. Purchases by the government from a domestic company also count, such as an airplane that the Air Force buys. Transfer payments, such as welfare benefits and social security distributions, do not count as government spending. Those show up as household consumption when the recipient spends the money.

The “I” represents investments by businesses in the property, plant, and equipment (PP&E) required to conduct their business. These capital expenses are factors of production that make running the business possible but are not consumed in the manufacturing of other products.

Finally, “X” stands for net exports. It captures the value of all the things made within the economy that are shipped outside the country. It then subtracts the value of all the things that are produced outside of the economy and consumed within the country’s borders.

For the United States, all of these values are estimated by the U.S. Bureau of Economic Analysis (BEA) every quarter. But they are collected in terms of what the items sell for at the time the data is collected. In order to account for inflation, these values must be adjusted into real dollars by using an inflation index.

There are two inflation indexes that are most commonly used. One is the consumer price index (CPI), and the other is called the GDP deflator. To adjust a present value into the equivalent base year value, you simply divide the nominal GDP by the index value, divided by 100 to return the index value to percentage terms.

Base year real GDP = Nominal GDP / (index value / 100)

For example, the nominal GDP in 2018 was $20.6T, and the CPI was 251. You could convert the 2018 nominal GDP into the base year value by plugging in those values.

Real GDP = $20.6T / (251 / 100) = $8.2T

Because the CPI uses the average prices from 1982-1984 as the base year, this means that the $20T economy would be equivalent to an $8T economy nearly 40 years ago. The actual GDP in 1983 was $3.4T, so the economy has grown by more than inflation.

Alternatively, you may want to pull a previous year’s nominal value into current dollars to compare them. To do so, the equation looks like this:

Current year real GDP = (Nominal GDP * current index value) / index value

Let’s say you wanted to adjust the 2010 nominal GDP to 2018 dollars. The 2010 nominal GDP was $15T, and the 2010 CPI was 218. The conversion of 2010 nominal GDP into real GDP (in 2018 terms) would be:

2010 real GDP = $15T * 251 / 218 = $17.3T

In other words, the $15T economy in 2010 would be equivalent to a $17.3T economy in 2018. Since the actual GDP in 2018 was $20.6T, we can see that the U.S. economy has grown by $3.3T more than inflation.

What is the difference between using CPI and GDP deflator to determine real GDP?

The GDP deflator is an inflation index that allows you to adjust a country’s gross domestic product (GDP) for inflation. It is a slightly different measure than the consumer price index (CPI) but can be used in the same way and for the same purpose.

While CPI tracks the price of a certain “basket of goods” over time, the GDP deflator applies a previous price to the current spending patterns. For example, the CPI might track how milk, cheese, and eggs have changed between two years – regardless of how much of those items were actually purchased. The GDP deflator would look into your shopping cart and adjust the prices of the things you bought.

So, if you have eggs and milk in your cart, and if you were comparing 2019 to 1980, it would apply the price of eggs and milk from 1980 to your purchase. Then, it would compare that price to what you paid in 2019. The difference in price is the GDP deflator.

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