What Is Real GDP?:
Real GDP tells you how much the economy is producing. It is given as an annual rate that's calculated each quarter by the Bureau of Economic Analysis
(BEA). GDP stands for
Gross Domestic Product.
The Difference Between Real and Nominal GDP:
Real GDP takes out the effects of price increases. This allows you to compare the economy's production for each quarter more accurately. Otherwise, it might seem like the economy is producing more when it's just higher prices. Nominal GDP is the measurement that leaves
inflation in the estimate. Therefore, it's usually higher than real GDP.
How to Calculate Real GDP:
To calculate real GDP, the BEA omits
imports. It also excludes foreign income from American companies and people. That negates the impact of
exchange rates. The BEA takes out inflation by calculating the implicit price deflator. This is the ratio of what it would cost today compared to a base year. It's similar to the Consumer Price Index (
CPI), but is weighted differently. The BEA publishes implicit price deflators in NIPA table 1.1.9, which you can find in the
Interactive Tables.
How Does Real GDP Measure Production?:
Real GDP measures the final output of everything produced in the U.S. in the prior quarter. It does not measure sales. For example, the car is measured when it comes off the factory line and is shipped to the dealership. It is recorded as an addition to inventory, which increases GDP. When it is sold and driven off the lot, then it is recorded as a subtraction to inventory, and actually lessens GDP -- unless the factory builds another car to replace it.
GDP only counts final production.The parts manufactured to make the car -- tires, steering wheel, engine -- are not counted in GDP. (Source: BEA, GDP Primer)
How Does Real GDP Measures Services?:
Real GDP also measures services, such as your hairdresser, bank, and even the services provided by non-profits such as Goodwill. It also includes services provided by the U.S. military, even when troops are overseas. It also measures housing services provided by and for persons who own and live in their home, including maid service.
However, some services are not measured because it is too difficult. These include unpaid childcare, elder care or housework, volunteer work for charities, or illegal or black-market activities. (Read The Real Wealth of Nations to see why this could provide a false measurement of wealth.)
Why Is Real GDP Important?:
Real GDP is important for two reasons. First, it tells you how much the economy is producing. The GDP components tells you what parts of the economy are contributing the most. Real GDP can also be used to compare the size of economies throughout the world. However, to fairly compensate for different standards of living between countries, you must use purchasing power parity. Find out how to compare GDP by country.
Real GDP is also used to compute economic growth, known as the
GDP growth rate. This is calculated by comparing each quarter to the previous one. If real GDP were not used, then you wouldn't know whether it was real growth, or just price and wage increases. Real GDP can then be used to determine if the U.S. economy is growing more quickly or more slowly than the quarter before, or the same quarter the year before. In this way, you can tell where the economy is in the
business cycle. The
ideal GDP growth rate is between 2-3%. By the way, the BEA revises its quarterly estimate each month, as it receives better data. For a summary of all GDP growth reports since Q4 2006, see
GDP Current StatisticsThe GDP growth rate is critical for investors to adjust the
asset allocation in their portfolios. They also compare countries' GDP growth rates -- countries with strong growth attract more investors for their corporate
stocks, bonds and even their own sovereign debt.
The Federal Reserve reviews GDP growth when deciding on the Fed funds rate. It will raise the rate when growth is too fast, and lower it when growth is too slow.
How GDP Affects You:
For example, when the GDP growth rate is slowing down or even contracting, the Fed will lower
interest rates to stimulate growth. If you are buying a home when this happens, you'd want an
adjustable-rate mortgage so you can take advantage of future lower rates. You might even want think about downsizing, since declining GDP growth rates can also lead to a
recession, which means layoffs.
If GDP growth rates are increasing, then you'd want to consider a fixed-rate mortgage. That way, you can lock in low interest rates, because the Fed usually raises them if growth is too fast. Either way, you want to stay on top of current GDP statistics, so you know which way the economic wind is blowing.
GDP Frequently Asked Questions:
