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What Is Real GDP?
Real gross domestic product 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 a fluctuation in prices, and it is a more accurate representation of a country’s economic activity.
- When real GDP tallies up the value of goods and services, only “final goods” are counted. This avoids double-counting items.
- For instance, the value of a watermelon from a farm may be $1, then $5 at the grocery store. In this example, the watermelon’s “final good” value is $5, so the total value of the good would be counted in the country’s income as $5.
When accounting for services, real GDP includes everything from hairdressing services to those of non-profit organizations. However, it doesn’t count services that are too difficult to measure, including unpaid childcare, volunteer work for charities, or black-market activities.
How Do You Calculate Real GDP?
To calculate real GDP, you must first have both the nominal GDP and the deflator, which is a price index (like the Consumer Price Index) used to measure inflation against a base year.
Nominal GDP is made up of a country’s total consumption (C), investment (I), government spending (G), and net exports (X).
The formula for calculating nominal GDP is the following:
GDP = C + I + G + X
The next step in calculating real GDP is to find the deflator. The U.S. Bureau of Economic Analysis calculates and publishes the GDP deflator for the U.S. every year.
Once you have both nominal GDP and the deflator, the formula for calculating real GDP is as follows:
GDP = Nominal GDP / Deflator
What Are the Advantages of Real GDP vs. Nominal GDP?
There are some advantages of real GDP over nominal GDP. These include:
- Accuracy. Nominal GDP is limited, because it assumes constant prices, meaning it simply includes spending without taking into account the natural rise and fall of prices. For example, one year the price of beef at the grocery store could be $50, and three years later it could be $55—when nominal GDP is calculated factoring in the $5 increase in the price of beef, it will show a rise in spending and therefore look like a rise in a country’s output, even though the economy not has actually grown. Real GDP does not assume constant prices, and it is less limited than nominal GDP. By adjusting for inflation or deflation, real GDP gives a more accurate picture of a country’s purchasing power and the annual rate of real economic growth or recession from year to year.
- Growth rate. By comparing real GDP from different years, you can calculate the real GDP growth rate, which you cannot do using nominal GDP. Governments use their GDP growth rate to determine how to adjust their finances or interest rates. In the U.S., the Federal Reserve uses the GDP growth rate to decide when to raise or lower interest rates—it raises the rates when growth is fast and lowers them when growth is slow.
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