Economists track real gross domestic product (real GDP) to determine the rate at which an economy is growing without any of the distorting effects of inflation. The real GDP number allows them to measure growth more accurately. Real GDP is a more accurate gauge of the change in production levels from one period to another, but nominal GDP is a better gauge of consumer purchasing power. In this article, we'll explore the difference between real GDP and nominal GDP as well as specific situations where real GDP is favorable.
Key Takeaways
- Nominal GDP is the total value of all goods and services produced in a given time period, usually quarterly or annually.
- Real GDP is nominal GDP adjusted for inflation.
- Real GDP is used to measure the actual growth of production without any distorting effects from inflation.
- Real GDP is useful in setting public policy, analyzing inflation, and making business decisions.
- Nominal GDP may be favorable for simpler calculations or during periods of low inflation.
How GDP Is Calculated
The Bureau ofEconomic Analysis (BEA), a federal agency, calculates real GDP by removing the effects of inflation from the numbers using a GDP price deflator. The deflator is the difference in prices between the current year and the base year chosen by the BEA for comparison. For example, if prices rose by 5% since the base year, the deflator would be 1.05.
Nominal GDP is divided by this deflator (which will be referenced to a specific base year), yielding real GDP. In times of inflation relative to the base year, the real GDP will be lower than the nominal GDP. In times of deflation, real GDP will instead be higher. Real GDP may be reported as the "inflation-adjusted" or "constant dollar" GDP, while nominal GDP may be reported as the "current dollar" GDP. The BEA reports both figures in its quarterly and annual reports on GDP.
Real GDP vs. Nominal GDP: An Example
Before we dive deeper into real GDP, let's walk through an example comparing real GDP to nominal GDP. Suppose we have an economy that produces only one good: widgets. In the year 2022, the economy produced 1,000 widgets, and each widget sold for $10.
Nominal GDP Calculation for 2022:
Nominal GDP = Quantity of Widgets × Price per Widget
Nominal GDP = 1,000 widgets × $10/widget = $10,000
Now let's consider that in the year 2023, the economy produces 1,200 widgets, but the price per widget has increased to $12 due to inflation.
Nominal GDP Calculation for 2023:
Nominal GDP = Quantity of Widgets × Price per Widget
Nominal GDP = 1,200 widgets × $12/widget = $14,400
Now, let's calculate real GDP to account for inflation using a hypothetical price index (GDP deflator). Let's assume the GDP deflator for 2022 is 100 and for 2023 is 120 (based on the prices of $10 and $12).
Real GDP Calculation for 2022:
Real GDP = Nominal GDP / GDP Deflator for 2022
Real GDP = $10,000 / 100 = $10,000
Real GDP Calculation for 2023:
Real GDP = Nominal GDP / GDP Deflator for 2023
Real GDP = $14,400 / 120 = $12,000
Comparing the two years, nominal GDP increased from $10,000 in 2022 to $14,400 in 2023. However, when we account for inflation, we see that real GDP only increased from $10,000 to $12,000. This indicates that the economy's actual production of goods and services, adjusted for changes in prices, grew by a more modest amount as over half of the supposed economic growth was simply due to inflation.
In inflationary periods, real GDP will be lower than nominal GDP. In deflationary times, real GDP will be higher.
Why Real GDP Matters
The total amount that the economy is producing and consuming is important to track over time. It is a key indicator of the overall health and growth of the economy, and it is used to determine economic policy going forward. These decisions affect the entire economy. If real GDP growth is low or negative, the Federal Reserve may deploy a different strategy.
Below is a variety of circ*mstances in which real GDP is used and is often more favorable than nominal GDP. Note that this list is not meant to be fully inclusive, and there may be circ*mstances where nominal GDP may be favorable at times.
Analyzing Inflation
By comparing nominal GDP and real GDP, economists can assess the extent to which rising prices and inflation are affecting economic growth. If nominal GDP grows faster than real GDP, it suggests that a portion of the growth is due to increased prices rather than actual production growth.
Setting Monetary Policy
Central banks such as the Federal Reserve use real GDP data to guide their monetary policy decisions. If real GDP is growing too slowly, central banks might implement expansionary monetary policies to stimulate economic activity. Conversely, if real GDP is growing too quickly and inflation is a concern, they might adopt contractionary policies to curb inflation.
Setting Fiscal Policy
Governments may also use real GDP data to assess the impact of fiscal policies such as changes in taxation and government spending. Real GDP helps policymakers understand the actual effect of these policies on economic output, as nominal GDP is more likely to be misleading as to how robust an economy is actually operating.
Understanding Unemployment
In some cases, real GDP is closely linked to employment levels. When the economy is growing and real GDP is increasing, businesses tend to hire more workers to meet the rising demand for goods and services. Conversely, during economic downturns, real GDP tends to contract, leading to job losses. Though the relationship between real GDP and unemployment does not always move in tandem, the general notion is that analysts and economists can forecast that economic growth and demand for labor may sometimes overlap.
Implementing Business Strategy
Companies use real GDP data to make informed decisions about their operations. Economic growth can signal potential opportunities for expansion, while slower growth might lead businesses to be more cautious in their investment and expansion plans. This may extend to forecasting what customer demand may be (due to future changes in income levels or disposable income) or what future rate curves may be.
Attracting International Investment
Real GDP influences a country's attractiveness for international investors and trade partners. A growing economy with a rising real GDP may encourage foreign investments and trade relationships, as it suggests a healthy business environment.
Considering Sustainability Practices
Real GDP growth is closely tied to resource consumption and environmental impact. Sustainable economic growth aims to balance economic expansion with environmental conservation, ensuring that growth is both equitable and environmentally responsible. For example, consider how the demand for energy or gas may be higher during economic expansion due to increased demand for raw materials as consumer demand is higher. Monitoring current and projected real GDP allows environmentally-conscious manufacturers to plan accordingly.
Real GDP can be negative if the economy's output contracts significantly and the deflator-adjusted prices decline. A negative Real GDP suggests a severe economic downturn.
When Real GDP Is Less Favorable
There's a handful of situations where nominal GDP may actually be better to use compared to real GDP. For short-term business decisions such as adjusting prices or inventory levels in response to immediate market conditions, nominal GDP can provide a snapshot of current consumer spending patterns that are often impacted by inflation. Companies might also need to assess their revenue and cost structures in real-time without adjusting for inflation.
Nominal GDP figures are often reported in the media and used in public discussions about the economy. They provide a quick and easily digestible measure of economic performance that can resonate with the general public. Even though it may not always truly portray a completely accurate depiction of what is occurring in the economy, nominal GDP is a more digestible calculation that is simply easier to report.
In periods of relatively stable inflation, nominal GDP might serve as a reasonable approximation of economic growth. When inflation rates are low and not significantly distorting price levels, nominal GDP may likely be close to real GDP. This is also true when comparing nominal GDP across periods in which inflation was minimal across all periods.
What Does a Higher Real GDP Growth Rate Indicate About an Economy?
A higher real GDP growth rate indicates that an economy is producing more goods and services over time, contributing to economic expansion, improved living standards, and increased job opportunities.
What Are the Limitations of Using Real GDP As an Economic Indicator?
Real GDP doesn't capture all aspects of economic well-being, such as income distribution, environmental impact, and quality of life. It also doesn't account for non-market activities and improvements in product quality. Last, real GDP intentionally strips away inflation which may be a primary component of an economy's focus and make-up.
How Does Real GDP Per Capita Differ From Real GDP?
Real GDP per capita divides Real GDP by the population, providing a measure of economic output on a per-person basis. It helps account for changes in population size when evaluating living standards.
What Are the Implications of a Growing Gap Between Nominal GDP and Real GDP?
A growing gap between Nominal GDP and Real GDP indicates increasing inflation. This can have economic consequences such as reduced purchasing power and potential distortions in economic decision-making. Be mindful of how public portrayal of nominal GDP may be misleading in these cases, as true economic growth may be substantially less during periods of a widening gap between the two.
The Bottom Line
Real GDP is inflation-adjusted gross domestic product. It measures an economy's output accounting for changes in prices. It's most valuable for assessing economic growth across time, comparing different countries' performance, guiding policy decisions, understanding unemployment dynamics, and determining living standards.
