What is Real GDP?

Key Takeaways

  • 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 Formula

You are free to use this image on you website, templates, etc., Please provide us with an attribution linkHow to Provide Attribution?Article Link to be HyperlinkedFor eg:Source: Real GDP (wallstreetmojo.com)

Where,

  • 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.read more is a measurement of inflation

Explanation

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 compared to the base year of the deflator. 

Examples

Example #1

Suppose that the economy’s GDP is $2 million, and since the base year, the prices of the economy have increased by 1.5%. You are required to calculate real GDP based on these estimates. 

Solution

  • Nominal GDP: $2,000,000Deflator Rate: $1.015

Therefore, calculation of real GDP can be done using the above formula as,

= $2,000,000/ (1+1.5%)

=$2,000,000 /(1.015)

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

Example #2

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 been asked to calculate real GDP based on below information provided by his senior.

  • Private Consumption Expenditure: 1000000Government Expenditure: 5000000Private Domestic Expenditure: 2500000Exports: 1500000Imports: 9000000

Solution:

Based on the above information, you must calculate the real GDP, assuming the inflation was 2% compared to the base year. Here, we are not given 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.read more, we need to add all the expenditures and exports and reduce imports since that was not produced.

Therefore, the nominal GDP calculation can be done as follows

Nominal GDP = 10,00,000 + 50,00,000 + 25,00,000 + 15,00,000 – 90,00,000

Nominal GDP = 10,00,000

Therefore, the calculation of real gross domestic product can be done using the above formula as,

=  10,00,000 /(1+2.00%)

=10,00,000/(1.02)

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

Example #3

Rico is an emerging country. Mr. Waffet is considering investing in Rico and is long in the country. However, some of the 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, the 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: 115000Wages Earned by Labor: 420000Corporate Profits: 287500Depreciation: 172500Indirect Taxes Paid: 35000

You are required to calculate real gross domestic product, assuming that the inflation rate compared to the base year was 3%.

Solution:

Here, we are not given 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.read more 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 as,

= 10,30,000/(1+3.00%)

= 10,30,000/(1.03)

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.

Relevance and Uses

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.read more. 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.

This has been a guide to real GDP and its definition. Here we discuss the formula to calculate real gross domestic product (GDP) and practical examples. You can learn more about financial analysis from the following articles –

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.

  • 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.read moreFormula 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 + NXread moreNominal 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.read moreLagging Indicators