What is real GDP? Understanding the tool economists and governments use to manage the economy
- Real GDP (gross domestic product) is a measure of all the goods and services produced in a nation adjusted for inflation or deflation, expressed in dollars.
- Economists prefer real GDP over other calculations because it adjusts for price changes, presenting a more accurate picture of production growth.
- Markets' and governments' reactions to real GDP data — changing interest rates or taxes — can impact individuals and influence their investing decisions.
The ability to assess the health of an economy can help a government to plan its fiscal policy, a central bank to plan its monetary policy, businesses to plan for the future and employment, and individuals to plan for their lives.
Gross domestic product (GDP) is one of the key assessment tools they use.
In literal terms, GDP measures all of a nation's economic output — that is, all the goods and services produced — within a certain time frame. In broad terms, it measures a nation's overall financial health, indicating if an economy is growing or slowing down.
When talking about GDP, it's important to understand there are two different types: real GDP and nominal GDP. And understanding how both are calculated can help you interpret how policymakers take their nation's economic temperature. Here's what you need to know.
What is real GDP?
Let's start from the top: Economists use GDP to calculate a nation's economic output. GDP totes up the sum of private consumption/expenditures, gross investments, government spending, and exports minus imports throughout a country. The sum is expressed as a dollar figure (or whatever the national currency is).
Economists believe that the ideal GDP growth rate should be between 2% and 3% annually.
The GDP numbers and their change signal the growth or decline in an economy. When an economy is growing, consumer spending is high and businesses are producing more and hiring more people. When an economy slows down, people spend less, resulting in a decrease in production and less employment.
In the US, GDP is calculated by the Bureau of Economic Analysis (BEA). BEA uses two types:
- Nominal GDP, also known as current-dollar GDP
- Real GDP
Both consider the same factors. The key difference: Nominal GDP reports the numbers using current dollar values. So it reflects both price increases and output increases. Real GDP just measures actual increases in output — it accounts for inflation or deflation, stripping away any price changes.
Real GDP vs. nominal GDP
Real GDP is considered by economists to be a more accurate measure of economic output than nominal GDP. Because GDP is reported in dollar terms, larger figures in nominal GDP could indicate that the economy is growing — or it could just mean that costs are going up. Real GDP adjusts for changes in price; it figures inflation or deflation into the equation.
Nominal GDP is a sufficient measure if used within a year, as it reports growth with that year's prices. However, when it comes to comparing growth from one year to the next, real GDP is a better metric.
Because it uses current dollar values, nominal GDP is usually higher than real GDP — at least, if an economy is expanding and prices are going up. But the reverse is true in a recession or depression that includes deflation. Both growth and prices would be down, resulting in nominal GDP being lower than real GDP.
In a growing economy with increasing prices, one can think of nominal GDP as an inflated number. In the reverse scenario, it is a deflated number.
Here's the difference between real GDP and nominal GDP for the same timeframe.
How to calculate real GDP
Real GDP is calculated by dividing nominal GDP by the GDP deflator.
The GDP deflator is provided by the BEA and measures inflation or deflation as a percent change from a base year, which is currently 2012. As of Q2, 2020, the GDP deflator is 112.87.
We can use an example from the end of 2019. The nominal GDP in the US at the end of 2019 was $21.7 trillion and the GDP deflator was 112.950. To determine real GDP, we calculate it as follows:
Real GDP = $21.7 trillion / 1.1295 = $19.2 trillion
What is the significance of real GDP?
The BEA publishes real GDP figures quarterly. And they invoke several types of responses.
Impact on government
When the GDP growth rate is slowing down or expanding too fast, a government and its central bank (like the Federal Reserve in the US) will take measures to correct the trend. These measures affect investors and individuals alike.
If the GDP growth rate is contracting, then the government will spend more money and decrease taxes, while the central bank will reduce interest rates, all with the intent of increasing the money supply available to individuals and businesses so that they spend more.
Increased spending spurs the economy, leading to an increase in demand, which leads to an increase in production, and finally an increase in the labor force. An increased labor force means more individuals with disposable income who are able to spend more. And so on.
Impact on investors
Stock markets also react to the quarterly publishing of real GDP figures. As GDP is an indicator of the health of the economy, and the stock market's moves include sentiments about the future, positive or negative real GDP numbers will move the markets in the corresponding direction.
Traders and investors often choose and time their transactions on real GDP releases and expectations. Similarly, retirement account managers and portfolio managers react to real GDP movements, making decisions about buying and selling their mutual fund holdings or changing the asset balance of their portfolios.
Impact on individuals
While GDP figures don't impact individuals directly, policymakers' reactions to them do.
For example, if the Fed reduces interest rates (to combat a contracting real GDP), it is a good time for individuals to take on debt, as the cost of borrowing is cheaper. If you wanted to buy a house, for example, you'd find the rates on mortgages have decreased. If you were already a homeowner, refinancing your current mortgage at the new lower rates would also be a strategic move.
However, if the contraction continues, it often eventually leads to layoffs and increased unemployment. So consumers might want to rein in their spending and bump up their savings, especially in conservative money market accounts or Treasury bonds.
The financial takeaway
GDP highlights what sector of the business cycle an economy is in. It's a macroeconomic measure, gag ing whether an overall economy is thriving or declining.
Understanding the difference between nominal GDP and real GDP is important because real GDP is an inflation-adjusted, and so more accurate, reflection of economic output.
Real GDP provides government policymakers with insight on troubling tendencies — suggesting that a recession, depression, or runaway inflation is looming — and how to prepare for and counter these issues.
Depending on changes in real GDP, individuals will have an idea of how the economy is performing, which will help them determine whether they should be spending money because times are good or if they should be saving money because the forecast doesn't look very bright.