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What Is Gross Domestic Product?
Gross Domestic Product (GDP) is the total market value of all of the goods and services provided from within the borders of a country during a set time period. GDP is most often used to measure the economic growth, purchasing power, and overall economic health of a nation. There are two primary ways of measuring GDP: nominal gross domestic product and real gross domestic product. The advantages of real versus. nominal GDP vary depending on how you’re using the final measure and whether you’d like to account for inflation.
What Is Nominal GDP?
Nominal GDP, or nominal gross domestic product, is a measure of the value of all final goods and services produced within a country’s borders at current market prices. Also known as a “current dollar GDP” or “chained dollar GDP,” nominal GDP takes price changes, money supply, inflation, and changing interest rates into account when calculating a country’s gross domestic product.
How Is Nominal GDP Calculated?
GDP measures the market value of all goods and services produced by a country. The US Bureau of Economic Analysis calculates this by multiplying price by quantity.
- In calculating nominal GDP, we only use current quantities at current year prices. This is achieved by using a consumer price index of the country’s basket of goods. Nominal GDP takes into account all the goods and services that are produced within a country’s borders at these current prices.
- If, for instance, the United States produced only three products—coffee, tea, and cannoli, let’s say—nominal GDP would be calculated by first multiplying the quantity of each product produced by its current market price, and then adding the three results together. In order to calculate it, we first need to know the quantity of each product produced and the up-to-date average price for that product.
- Therefore, (coffee quantity x coffee’s current market price) + (tea quantity x tea’s current market price) + (cannoli quantity x cannoli’s current market price) = Nominal GDP
- For instance, the U.S. could have produced 1 million pounds of coffee, which currently sells for $4/lb; 2 million pounds of tea, which currently sells at $2/lb; and 1 million cannoli, which sell for $1/pastry. With this information, we can now calculate this country’s nominal GDP by plugging it into the formula above.
- It can then be further reduced to the nominal GDP per capita by dividing the nominal GDP by the country’s population.
What Is Real GDP?
Real gross domestic product, or real GDP, is a measure of a country’s output in terms of the value of its goods and services, its investments, its government spending, and its exports. Real GDP takes nominal GDP and adjusts for inflation or deflation by comparing and converting prices to a base year’s prices. By adjusting for price changes, the final number won’t reflect false increases or decreases in GDP due to fluctuation in prices, and it is a more accurate representation of a country’s economic activity.
How to Calculate Real GDP
To calculate real GDP, you must first calculate nominal GDP for the deflator, which is a price index used to measure inflation against a base year.
The US Bureau of Economic Analysis calculates the GDP deflator for the US every year. It uses the year 2000 as the standard base year for prices and exchange rates, but the BEA also includes several other base years for a quick look at the rise in inflation as far back as 1937.
Once you have both nominal GDP and the deflator, the formula for calculating real GDP is as follows: GDP = Nominal GDP / Deflator
How Does Nominal GDP Compare to Real GDP?
While nominal GDP by definition reflects inflation, real GDP uses a GDP deflator to adjust for inflation, thus reflecting only changes in real output. Since inflation is generally a positive number, a country’s nominal GDP is generally higher than its real GDP.
- Economists typically use nominal GDP when comparing different quarters of output within the same year.
- But when comparing GDP across more than one year, economists use real GDP because, by removing inflation from the equation, the comparison only shows the change in output volume between the years. That means that real GDP growth reflects a country’s increased output and is not influenced by inflation increasing price level.
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