Jump To Section
How Is Real GDP Calculated?
In order to calculate Real GDP, the Bureau of Economic Analysis (BEA), the United States Department of Commerce organization charged with providing the nation’s official economic data, must consider two separate time periods: a base year, and the current year under study. This is necessary to calculate inflation between the two periods and then adjust GDP accordingly.
- To calculate real GDP, economists must first calculate nominal GDP by multiplying the quantity of goods a country has produced in the year under study by those goods’ current prices.
- This is done with a consumer price index of the country’s basket of goods, meaning the average price consumers pay for the goods and services a country produces.
- Economists calculate real GDP by then adjusting the resulting nominal GDP to account for inflation by applying a GDP deflator or a price index, which measures inflation since the base year. In this case, the base year is a year separate from the one under study, but whose prices will be used to measure it.
- For example, let’s assume economists are calculating real GDP for 2017, using 2016 as the base year. If 2017 prices increased by 8% over the base-year prices, the deflator would be 1.08, the number that expresses the change in price over time between 2016 and 2017.
- Dividing nominal GDP by this deflator number removes inflation from the result and yields an economy’s real GDP, which now expresses economic output without the influence of inflation.
What Does Real GDP Measure?
Real GDP measures a country’s total economic output as adjusted for price changes due to inflation.
- Comparing the real GDP from two different years reveals a country’s economic trajectory, telling economists if the country’s economy is growing, decreasing, or remaining stagnant, regardless of changes to price caused by inflation or deflation. Is a country making and selling more stuff than it did last year?
- It does not, however, tell us the real-time actual market value of a company’s economic output. Since it adjusts the market value of goods to account for inflation, it removes the context of the current economic moment and can prove misleading when trying to understand, for instance, the value of a country’s GDP according to prices in a specific moment.
What Does Real GDP Tell Economists?
Economists use real GDP to compare an economy’s purchasing power and growth over time. Essentially, by expressing two years of market value in the same average prices allows economists to understand the gross increase or decrease in economic output without being influenced by the inflation rate over time. This tells them if an economy’s output is increasing or decreasing over a period of time, regardless of changes in price.
Some of its uses include:
- Charting a country’s economic trajectory over time. By removing inflation, real GDP provides the most accurate figures by which to express and monitor an economy’s changes over time.
- Providing government institutions with relevant data for policy making. Output growth over time is a key figure for political and economic policymakers making decisions about interest rates and government spending. Consider the United States Federal Reserve (also known as the Fed), which considers real GDP when making decisions about raising or lowering interest rates.
- Allowing for comparison between multiple country’s economic output.
What Is the Difference Between Real GDP and Nominal GDP?
Nominal GDP uses the output and prices from a given year to express the total economic value a country produced under the time studied.
- This means that price increases or decreases (generally caused by inflation) will have as much sway over nominal GDP as the actual quantity of goods and services produced. Nominal GDP can be useful when comparing a country’s economic performance within the same year—on a quarterly system, for instance. Thus, nominal GDP is best used when looking for a snapshot of the total value of an economy’s output based on current market prices.
- Real GDP, on the other hand, expresses the total value with constant prices, which means economists isolate and then remove inflation from consideration. Consequently, real GDP provides a more accurate portrait of economic growth than nominal GDP because it uses constant prices, making comparisons between years more meaningful by allowing for comparisons of the actual volume of goods and services without considering inflation.
- It is thus a more accurate tool when considering the changes over time in an economy’s output level—economists use real GDP to monitor a country’s economic growth. Real GDP is a better tool to judge long-term national economic performance because it only takes into account the actual change in a country’s economic output.
- The best way to express the difference between the two terms is to consider the difference between positive growth to nominal GDP and real GDP: positive nominal GDP growth can be attributed to inflation; a positive real GDP growth rate, however, can only result from an increase in output.
Learn more about economics and society in Paul Krugman’s MasterClass.