What Is Real GDP?
Real GDP can be defined as an inflation-adjusted measure that reflects the value of services and goods that are produced in a given single year by an economy which can be expressed in the prices of the base year, and that can be referred to as constant dollar GDP, or inflation corrected GDP. Below given is the formula to calculate real GDP.
Analyzing the real GDP equation helps measure domestic production and the country’s economic health. This gives economists, investors, and leaders of the economy an idea of the economy’s health and the trends of the near future of the economy in question. It is a better indicator as a comparison with the base year’s GDP is possible.
Table of contents
- One can calculate the real gross domestic product by multiplying the nominal GDP by a deflationary number (N) or dividing the nominal GDP by the same (N).
- Real GDP is a measure of the value of services and goods generated in an economy in a certain calendar year that is corrected for inflation.
- Suppose there is a significant discrepancy between a country’s nominal and real gross domestic product. In that case, this indicates either a significant deflation (if the nominal is lower) or inflation (if the real is lower) in that country’s economy compared to the deflator’s base year.
Real GDP Explained
The real gross domestic product is derived as a nominal GDPNominal GDPNominal GDP (Gross Domestic Product) is the calculation of annual economic production of the entire country's population at current market prices of goods and services generated by four main sources: land appreciation, labour wages, capital investment interest, and entrepreneur profits calculated only on finished goods and services. over or dividing the same by a deflating number (N): (nominal GDP) / (N). Compared to the base year, the deflator can be considered the measurement of inflation. Finally, dividing the nominal GDP number by this deflatorGDP Number By This DeflatorThe GDP deflator measures the change in the annual domestic production due to changes in price rates in the economy. Hence, it measures the change in nominal GDP and real GDP during a particular year calculated by dividing the nominal GDP with the real GDP and multiplying the resultant with 100. shall remove any inflation effects.
Therefore, A huge difference between a country’s nominal and the real gross domestic product shall signify a substantial deflation (in case the nominal is lower) or inflation (in case the real is lower) in its economy in comparison to the base year of the deflator.
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How To Calculate?
- DeflatorDeflatorDeflation is defined as an economic condition whereby the prices of goods and services go down constantly with the inflation rate turning negative. The situation generally emerges from the contraction of the money supply in the economy. is a measurement of inflation
Let us understand the concept of real GDP growth with the help of a few examples and calculations.
Suppose an economy’s GDP is $2 million, and since the base year, the prices of the economy have increased by 1.5%. Let us use the real GDP calculator based on these estimates.
- Nominal GDP: $2,000,000
- Deflator Rate: $1.015
Using the above formula, let us calculate the real GDP:
= $2,000,000/ (1+1.5%)
Real gross domestic product will be –
Real gross domestic product = 1,970,443.35
Hence, the real gross domestic product is $1,970,443.35
ABC is one of the largest economies in the world. Mr. VJ has joined the statistics department which reports the country’s key statistics including gross domestic product calculation. Mr. VJ has to calculate real GDP based on the below information provided by his senior.
- Private Consumption Expenditure: 1000000
- Government Expenditure: 5000000
- Private Domestic Expenditure: 2500000
- Exports: 1500000
- Imports: 9000000
Per the above information, let us use the real GDP calculator, assuming the inflation was 2% compared to the base year. Here, we do not have a direct nominal GDP value; hence, we must first calculate the nominal GDP.
To calculate the nominal GDPCalculate The Nominal GDPThe nominal GDP formula is used to figure out the nation's gross domestic product at the current price without considering inflation. It is the total of private consumption, gross investment, government investment and trade balance., we need to add all the expenditures and exports and reduce imports since that was not produced.
Therefore, let us calculate the nominal GDP:
Nominal GDP = 10,00,000 + 50,00,000 + 25,00,000 + 15,00,000 – 90,00,000
Nominal GDP = 10,00,000
Let us calculate the real gross domestic product:
= 10,00,000 /(1+2.00%)
The real gross domestic product will be –
real gross domestic product = 9,80,392.16
Hence, the real gross domestic product is 9,80,392.16
Rico is an emerging country. Mr. Waffet is considering investing in Rico and is long in the country. However, some street analysts don’t agree with him. Mr. Waffet believes that Rico is on the verge of listing in the top 10 emerging markets as currently, it stands at 20 as per the list published. However, street analysts believe that if the real gross domestic product is more than 1 million, it can be in the top 10 list next year. One of the renowned statistics websites provides details about the country.
- Rent Income: 115000
- Wages Earned by Labor: 420000
- Corporate Profits: 287500
- Depreciation: 172500
- Indirect Taxes Paid: 35000
Let’s calculate real gross domestic product, assuming that the inflation rate compared to the base year was 3%.
Here, we don’t have the direct nominal GDP value, hence first we need to calculate the nominal GDP.
To calculate the nominal GDP, we just need to add all the income along with depreciation and indirect taxesIndirect TaxesIndirect tax, also known as consumption tax, is the type of tax the person does not directly bear. In contrast, the incidence of such taxes is passed on to the end consumer of goods or services by adding such taxes to the value of those goods or services, like Excise duty, Service tax, VAT, etc. since that reduces the gross income.
Therefore, Nominal GDP can be calculated as follows,
= 1,15,000 + 4,20,000 + 2,87,500 + 1,72,500 + 35,000
Nominal GDP = 10,30,000
Therefore, the calculation of real GDP can be done using the above formula:
real gross domestic product will be –
real gross domestic product = 10,00,000
Since the real gross domestic product is not more than 1 million, the country might fail to make it to the top 10 list.
Since the nominal GDP is calculated in the monetary value of all the services and goods produced, those shall be liable to change if there is a price changePrice ChangePrice change in finance is the difference between the initial and final values of an asset, security, or commodity over a particular trading period.. For example, falling prices will lead to a decrease in the nominal GDP, and rising prices will make the nominal GDP depict as bigger or, say, larger.
But again, these changes shall not affect or depict any change in the quality or the quantity of all the services and goods being produced. Because of this, it would be difficult to answer just from the nominal GDP whether the production of the country or the economy is expanding. Amending or providing the adjustment for price changes will solve this.
The result, that is the real gross domestic product shall provide a better judgment or better basis for concluding the long-term national economic performance of the country.
Frequently Asked Questions (FAQs)
While real GDP uses a GDP deflator to account for inflation and, as a result, solely shows changes in real output, nominal GDP, by definition, reflects inflation. Therefore, the nominal GDP of a nation is typically larger than the actual GDP because inflation is typically a positive number.
Real GDP paints a more accurate picture of economic growth than nominal GDP since it accounts for inflation. It allows for meaningful year-to-year comparisons of the actual volume of goods and services produced.
The exclusion of non-market transactions is one of its significant restrictions. The absence of consideration for or representation of the severity of societal wealth disparity. The lack of information on whether or not the country’s growth rate is sustainable.
This has been a guide to what is Real GDP. Here we explain the formula along with practical calculation examples and limitations of the concept. You can learn more about financial analysis from the following articles –
- Dollar-Cost AveragingDollar-Cost AveragingDollar-cost averaging is a strategy of mitigating the volatility risk while investing in the market. It suggests to divide the total amount to be invested in equal parts, and investing those parts at regular intervals.
- Formula of GDPFormula Of GDPGDP or gross domestic product refers to the sum of the total monetary value of all finished goods and services produced within the border limits of any country. GDP determines the economic health of a nation. GDP = C + I + G + NX
- Nominal GDP vs Real GDPNominal GDP Vs Real GDPNominal GDP is the annual production of goods or services at current prices, whereas Real GDP is the annual production of goods or services calculated at current prices minus the effect of inflation.
- Lagging Indicators