What Is Real GDP?
Real GDP is defined as a measurement of the economic output of a country minus the effect of inflation. GDP stands for Gross Domestic Product. 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 really just that prices are going up.
The Difference Between Real and Nominal GDP
Unlike real GDP, nominal GDP is the measurement that leaves price changes in the estimate. Therefore, nominal GDP is usually higher. Real GDP is always given in terms of a base year. Real GDP is what nominal GDP would have been if there was no price changes from the base year. Both real and nominal GDP are given as an annual rate. In the U.S., they are both calculated each quarter by the Bureau of Economic Analysis (BEA).
How to Calculate Real GDP
The formula for real GDP is nominal GDP divided by the deflator, or R = N/D. The deflator is a measurement of inflation since the base year. For example, if prices have gone up 2.5% since the base year, the deflator is 1.025. If the nominal GDP were 10 million, the real GDP would be 976,000 or 10,000,000/1.025 = 976,000.
To calculate real U.S. 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. However, you don't have to it calculate yourself, the BEA has done it for you for five different base years:
- Table 1.1.6. Real Gross Domestic Product, Chained Dollars (2005)
- Table 1.1.6A. Real Gross Domestic Product, Chained (1937) Dollars
- Table 1.1.6B. Real Gross Domestic Product, Chained (1952) Dollars
- Table 1.1.6C. Real Gross Domestic Product, Chained (1972) Dollars
- Table 1.1.6D. Real Gross Domestic Product, Chained (1987) Dollars
How Does It 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 It 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 Statistics.
The 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.
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.
Is GDP Overstated While Inflation Is Understated?
A reader asks:
You wrote that inflation is taken out of the calculation for GDP. Please provide more detail. Specifically, if non-durable goods are counted as production, but food and fuel are NOT counted for core inflation - would that not result in an exaggerated estimate of GDP growth?The BEA takes inflation out of the estimate of GDP so it can be compared realistically quarter-to-quarter, and year-to-year. The BEA uses a price index to deflate the current-dollar GDP estimate. If inflation were left in, then GDP would appear overstated. (Source: BEA, Updated Summary of NIPA Methodologies, November 2007)
Core inflation, which omits food and fuel, is used primarily by the Federal Reserve to guide monetary policy. The Fed uses core CPI because food and fuel prices vary so much throughout the year that. If the Fed changed the Fed Funds rate in response, it would be disruptive to the economy.
So, to your point, core inflation is understated, but it is really only used for a specific purpose. And the Fed does take food and fuel prices into account, as they do most other types of data. Article updated April 18,2014