How to Calculate Real Gross Domestic Product, Real GDP Formula

Real Vs. Nominal GDP Growth: Examples, Formula, How to Calculate

You've probably heard politicians and economists talk about "real GDP growth" and "nominal GDP growth" and wondered what the difference is. You should know the difference between these two economic progress measurements. Nominal GDP growth is linked to price inflation, but real GDP growth is the rise in goods and services generated in an economy. The real GDP indicates whether the economy is expanding and raising living standards. Companies produce and hire more as real GDP grows. Because enterprises charge more for the same goods, nominal GDP can rise. When you hear the most recent GDP numbers, ask if they're real or nominal. The difference matters.

Key Highlights

  • Real GDP better measures living standards. Real GDP growth indicates higher production of goods and services to meet population growth. However, increased prices might boost nominal GDP.

  • Real GDP growth measures production growth without price fluctuations.

  • Nominal GDP growth shows the raw market value of all national production.

What is Real Gross Domestic Product (GDP)?

The term "real GDP growth" describes the increase in purchasing power of a country's production after inflation has been deducted. Real GDP is adjusted for price fluctuations and measures economic growth better than nominal GDP.

GDP grows 5% per year, but inflation is 3%, hence real GDP growth is 2%. Higher prices contributed to nominal GDP growth, not only more products and services. Real GDP strips out the price effect.

Real GDP is also a better measure for policymakers. If real GDP growth slows, it may signal the need for economic stimulus. Nominal GDP wouldn't provide that warning, and policymakers might fail to take action, risking an economic downturn.

Real GDP gives you a clearer picture of changes in a nation's actual output. While nominal GDP has its uses, too, for understanding economic growth and living standards, real GDP is the statistic that matters most. Focus on that, and you'll gain insight into a country's financial health and prosperity.

How Do You Calculate the Real GDP?

The real GDP is calculated by dividing the nominal GDP using a GDP deflator. The GDP deflator gauges the pricing of new items offered on a nation's domestic market. Prices for companies, the government, and individual customers are all included. 

The Real GDP formula can be represented as:

Real GDP = Nominal GDP / Deflator

or R = N / D

N or Nominal GDP = C + I + G + (X − M)

D or Deflator = Nominal GDP / Real GDP

Where,

C = Consumption

I = Investment

G = Government spending

X = Exports

M = Imports

For Example

An indicator of inflation since a base year is the GDP deflator. Inflation is eliminated by dividing the nominal GDP by the Deflator. The deflated statistic would be 1.01 if prices in an economy had increased by 1% from the base year. If the nominal GDP was $1,000,000.01, the real GDP formula is $1,000,000 / 1.01 or $990,099, respectively.

What Is Nominal GDP?

Nominal GDP growth is the annual market worth of all goods and services produced in a country. Unlike real GDP growth, it includes inflation. If prices rise 5% and the economy produces 3% more products and services, nominal GDP growth is 8%.

Businesses and investors value nominal GDP growth because it shows how much people spend. However, real GDP growth shows how much the economy is growing. It helps you see past price surges to assess growth strength.

                                                            

In today's low but constant inflation, nominal numbers usually surpass real numbers. Real GDP is a good indicator of economic health. Nominal growth is useful, but it can hide the truth. Real growth cuts through the noise to show you the truth.

How do we calculate Nominal GDP?

The GDP deflator multiplied by real GDP yields the nominal GDP the quickest to compute:

Nominal GDP = Real GDP × GDP Deflator

The formula to calculate nominal GDP is real GDP multiplied by the GDP deflator.

It can also be determined by applying the expense method:

Nominal GDP=C+I+G+(X−M)

Where:

C=Consumer spending

I=Business investment

G=Government spending

X−M=Total net exports

For Example

Consider a country whose economy is booming. It has:

Gross domestic consumption of $5 trillion

Gross investments of $10 trillion

Government investments are $4 trillion

Exports are $2 trillion

Product imports are $1 trillion. 

So, the country's nominal GDP stands tall, reflecting its economic prowess, which would be:

Nominal GDP = 5+10+4+(2-1)=20

The Nominal GDP will be $20 trillion.

What is the Crucial Difference between Nominal GDP and Real GDP?

Nominal GDP determines the market value of goods and services generated yearly at current or market prices. Real GDP is the annual worth of goods and services generated at constant prices. Real GDP accounts for inflation, while nominal GDP does not.

Real GDP is a stronger economic growth indicator since it excludes growing prices. Rather than more robust production, nominal GDP may have increased due to inflation. Real GDP growth indicates production expansion, not just higher prices.

Real GDP is a better long-term indication of economic growth and quality of life. Real GDP illustrates what's happening on Main Street, unlike nominal GDP, which may appear to expand swiftly due to inflation. Governments and economists prefer real GDP to track economic growth and compare across time.

Example

Real GDP is lower than nominal GDP during inflation and higher during deflation. Let's assume a fictional nation. Assume that the nominal GDP rose by 50% from $100 billion in 2000 to $150 billion in 2020. Inflation reduced the dollar's buying power by 50% throughout that time.

The economy appears strong based on nominal GDP alone. When expressed in 2000 dollars, real GDP is $75 billion, indicating a net loss in economic growth. Economists prefer real GDP to measure economic success due to its precision.

Real GDP is always lower than nominal GDP when inflation occurs. Real GDP would be 2% if nominal GDP rose 5%, but inflation was 3%. Inflation is the difference between growth rates. Taking price movements out, real GDP shows better production and economic performance.

Is Real GDP Higher or Lower Than Nominal GDP?

With inflation considered, real GDP growth represents the genuine rise in producing goods and services. In contrast, nominal GDP growth incorporates inflation. Real GDP falls below nominal GDP under inflation.

Why is that relevant? Even when quantities remain constant, inflation raises the price of the same goods and services. Therefore, nominal GDP can exaggerate economic growth. Real GDP eliminates price rises to better reflect economic development.

For example, say last year, when prices were stable, an economy produced $10 trillion of goods and services (its nominal GDP). This year, prices rose 10%, but quantities stayed the same. 

The nominal GDP would be $11 trillion, up 10% from last year. However, real GDP would still be $10 trillion since quantities didn't change - it removes the inflation effect. Therefore, real GDP growth would be 0%, while nominal GDP growth is 10% - overstating the actual growth.

Economic inflation occurs annually. With time, the difference between nominal and real GDP increases. Real GDP is the key to understanding the state of the economy and whether or not living standards are changing. While strong nominal GDP growth sounds fantastic, low real GDP growth may indicate high inflation and less money for people.

Why Do Economists Use Real GDP Rather Than Nominal GDP?

Since real GDP is unaffected by price changes and represents just changes in the amounts produced, economists prefer using real GDP over nominal GDP to measure economic well-being. One cannot ascertain whether higher pricing or increased output is responsible for nominal GDP growth.

Monitoring the economy's overall production and consumption levels throughout time is essential. It is a crucial sign of the economy's general health and growth and is used to set future economic policies. These choices impact the whole economy. The Federal Reserve may use an alternative tactic if real GDP growth is weak or negative. During inflation, real GDP takes a dip below nominal GDP. During deflation, real GDP soars!

Here are some situations when real GDP is applied, and it's usually preferable to nominal GDP. Please note that this is not a complete list, and there may be situations in which nominal GDP is advantageous.

1- Examining Inflation

Comparing nominal and real GDP helps economists assess how inflation and rising prices affect economic growth. As nominal GDP grows faster than real GDP, price rises may contribute to production growth.

2- Setting Monetary Policy

Central banks, including the Fed, base monetary policy on accurate GDP statistics. Central banks may utilize expansionary monetary policies to promote economic activity in slow real GDP growth. They may undertake contractionary policies if real GDP growth is too fast and inflation is a concern.

3- Setting Fiscal Policy

Using real GDP numbers, governments may analyze fiscal measures like tax and spending changes. Real GDP helps policymakers understand how these measurements affect economic production because nominal GDP is more prone to misrepresent an economy's strength.

4- Implementing Business Strategy

Businesses base operational decisions on GDP data. Faster growth may imply expansion opportunities, whereas slower growth may make firms more cautious in their investment and development ambitions. This may include predicting rate curves and customer demand (due to disposable income changes).

5- Gaining Foreign Investment

Actual GDP influences a country's attraction to overseas investors and traders. Real GDP growth indicates a strong business climate, which may attract foreign investment and trade.

Which country has the highest GDP?

The US boasts the world's biggest economy, with a whopping GDP of USD 26,854 billion. China and Japan take the bronze and silver positions, respectively. China's economy is almost the biggest since it keeps making significant investments in economic expansion. The following countries on this ranking list include India, Germany, and the United Kingdom.

Which country has the lowest GDP in the world?

Compared to other countries, Nauru is regarded as the country with the lowest GDP in the world. It has a GDP of $133.2 million. Some nations with low incomes include the Marshall Islands, Palau, São Tomé and Príncipe, the Federated States of Micronesia, and others.

Final Words

So there you have it, the critical differences between real and nominal GDP growth explained. While nominal GDP can quickly sense the economy's overall size and growth, real GDP determines actual economic progress. Nominal numbers can be misleading since they don't account for inflation. Only by factoring in inflation and calculating real GDP can you understand if output and living standards are increasing. The next time you read about quarterly GDP figures in the news, check if they report real or nominal numbers. Real GDP growth accurately indicates a strengthening, stable, or weakening economy.

FAQs

Why is Real GDP better than Nominal GDP?

Real GDP accounts for inflation and price movements, making it more accurate than nominal GDP. It measures the whole economy. Conversely, nominal GDP may not necessarily indicate the economy's status or future trajectory. The current market price is used in its computation. It can only be compared to non-inflation-adjusted measurements.

Why Is It Important to Measure Real GDP?

Higher living standards and increased production of products and services are found in nations with larger GDPs. Political leaders and others consider GDP growth a crucial indicator of national prosperity and interchange the terms GDP growth and economic growth. GDP can help policymakers and central banks predict economic growth, contraction, recession, and inflation. By accounting for inflation, real GDP better tracks output changes over time.

What's the key difference between Real GDP and Nominal GDP?

Nominal GDP values the goods and services at current prices, while Real GDP values them at base-year prices. Real GDP is Nominal GDP adjusted for inflation, allowing for a more accurate comparison to the base year.

What is nominal GDP and real GDP growth?

Using actual market prices or values, nominal GDP calculates a country's yearly output of goods and services. Real GDP accounts for inflation to assess goods and services.

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08 Dec, 2023

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