The gross domestic product (GDP) is one of the most commonly cited economic indicators of economists, investors and policymakers. Real GDP is an offshoot of the standard GDP metric that provides clarity on the economic health of a nation while factoring in inflation and prices. As such, knowing how to calculate real GDP is extremely important.
To fully understand real GDP, we need to first understand GDP. GDP along with unemployment rate is probably the most commonly cited economic health indicator of a nation. If you watch CNBC or read stock market or even political analysis, GDP will get mentioned quite frequently. GDP reflects the economic health of the nation, and therefore, it can affect a politician’s reelection chances, it can impact policy decisions, and it can be a factor for consumer and business confidence in the economy.
Simply put, GDP attempts to represent the value of all goods and services produced by the country during a period of time. Often times GDP is expressed as a growth rate, essentially indicator whether or not GDP is growing or not, and how fast. And as an implication, whether or not the economy itself is growing, and how fast. You might consider GDP to be the size of the economy, and the GDP growth as an indicator for the growth rate of the economy.
To calculate GDP, we add together personal and public consumption, public and private investment, government spending and net exports (exports minus imports). This is referred to as the expenditure method of calculating GDP. The alternative, and less common, approach is the income approach which attempts to add up all employee compensation, gross profits for businesses and taxes (less any subsidies).
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Nominal GDP vs. Real GDP
When learning how to calculate real GDP, we need to consider the differences between nominal GDP and real GDP.
Nominal GDP is the calculation of GDP at current market prices. It doesn’t care about how much those prices have been inflated or deflated recently.
Real GDP is the calculation of GDP while factoring in prices of a base year. The purpose here is to abstract out the impact of rising (or declining) prices. By removing the price variability, real GDP is then said to provide a better view into true economic growth.
If you think about it, we’re measuring GDP by adding up all the spending of the various parties within the economy. The spending is essentially quantities of goods and services times the prices of those goods and services. If GDP went up from one year to the next, but all of the increase is attributed to the increase in prices, then it could be that there is no true underlying growth of the economy. Instead, there’s just inflation. Typically, there is a combination of real growth and inflation (or deflation), but being able to decipher and measure the impact of each is important for quality economic analysis. Hence, the importance of real GDP and knowing how to calculate real GDP.
How to calculate real GDP
In order to calculate real GDP, we must decide on a base year and take the prices of the goods and services from that base year. For example, if the year 2000 were used as the base year, and we want to know the real GDP for the year 2019, we will take the quantities of goods and services purchased in the year 2019 and multiple those by the prices of those same goods and services from the year 2000. This is how we can achieve a measure of real GDP.
Next, we can take both the nominal and real GDP for a given year and plug them into a formula to determine the GDP deflator. The GDP deflator is useful for tracking price increases and decreases. You can determine the GDP deflator by using the formula: nominal GDP / real GDP x 100.
Note that the GDP deflator can be a useful tool for measuring inflation. Like the consumer price index (CPI), it attempts to provide economists a glimpse into how prices are rising or falling int he economy.
If you know the GDP deflator value, you can also calculate real GDP using the nominal GDP and the deflator as follows: real GDP = nominal GDP / GDP deflator. The Bureau of Economic Analysis calculates the GDP deflator each year. Again, it attempts to provide insight into the inflation levels since the determined base year.
Real GDP formula
To sum up, the real GDP formula can be reduced to R = N / D. Or, real GDP = nominal GDP / GDP deflator.
Depending on what data you already have, you can plug in various values into the real GDP formula in order to solve for the missing value.
For example, if you have nominal GDP of $20 trillion and you have the GDP deflator from the Bureau of Economic Analysis of say, 1.25, you can plug each of these values into the real GDP formula to solve for real GDP. Real GDP = $20 trillion / 1.25. Solving this gives you a real GDP value of $16 trillion. Obviously, this is just an example. Typically the difference between nominal GDP and real GDP isn’t as large as this example.
When might it make sense to reference nominal GDP vs. real GDP?
Nominal GDP is useful when you’re comparing GDP to other metrics or variables that don’t have inflation factored into them. A common example here is when comparing GDP levels to debt levels of the country. Since a country’s debt levels are in nominal terms, it makes sense to use nominal GDP.
Political pundits often like to bemoan the debt levels of the United States (or other countries), but just a nominal debt amount doesn’t give us much information because there is no context (plus we tend to get numb to obscenely large numbers). But, by looking at how much sovereign debt has expanded in relation to how much GDP has expanded, we can understand more clearly whether or not the debt levels are getting into troublesome areas or not. In theory, as long as GDP is keeping up with debt levels, the country shouldn’t have an issue with maintaining and servicing the debt. Obviously, what the appropriate level of debt of the country should or shouldn’t be is a much more complex issue than we’re discussing here, but you get the point.
However if you’re curious, you can get a glimpse of the U.S. debt to GDP ratio of recent years according to tradingeconomics.com.
How to calculate real GDP: Examples
Let’s look at some actual examples from the recent years in the United States economy.
2018 Nominal GDP vs. Real GDP and calculating GDP growth
In 2018, the nominal GDP was $20.58 trillion and the real GDP was $18.638 trillion. In the previous year, the nominal GDP was $19.519 trillion and the real GDP was $18.108 trillion. We can take these numbers to determine the growth rate of GDP from 2017 to 2018.
First we need the increase of real GDP from 2017 to 2018. We do this by subtracting 2018 real GDP by 2017 real GDP, or $18.638 trillion – $18.108 trillion = $0.53 trillion. Now we take that number and divide it by the 2017 real GDP number, or $0.53 trillion / $18.108 trillion = .029268. Let’s then take that and multiply by 100% to get 2.9%.
GDP grew by 2.9% from 2017 to 2018.
2009 Real GDP: The recession
We all know that the economy took a major hit in 2008 and the economic growth going into 2009 was really ugly. How ugly? Well let’s look at the data.
Let’s check out the real GDP numbers for 2008 and 2009.
2008: $15.605 trillion
2009: $15.209 trillion
We can determine the GDP growth rate in a similar was as the previous example.
$15.209 trillion – $15.605 trillion = -$0.396 trillion
-$0.396 trillion / $15.605 trillion x 100% = -2.5%
These calculations tell us that 2009 GDP contracted by 2.5% from the previous year. When the economy contracts at all, it’s a big deal. For it to contract by 2.5% we know that the economy was in dire straights during that time period.
Why GDP and real GDP is important
Politicians, investors, policymakers and more all pay attention to the quarterly GDP data that comes out. A surprise GDP number that gets released, whether to the upside or the downside, can often move the stock market in significant ways. It can also frame the economic policies of a sitting president for much of the public.
When economic growth is positive, it tends to have an effect on the stock market as well as business and consumer confidence. All of these elements work together to provide a positive flywheel effect on the economy where businesses are earning more money, employing more people and consumers are spending more money… which leads to businesses earning more money.
On the flipside, this economic reinforcing cycle can occur in the negative direction as well. If GDP is contracting, it can lead to businesses losing money, laying off individuals, which means individuals spend less… which leads to businesses losing more money. The Federal Reserve often steps in in these circumstances to provide stimulus to avoid this negative reinforcing cycle to continue. Real GDP is indeed one of the metrics that the Federal Reserve members follow closely.