GDP, or Gross Domestic Product, is one of the most-watched economic indicators in the U.S. economy. It is an important measure of the health and stability of the nation’s economic health. Movement in the stock market is often associated with positive or negative GDP reported results. Thus, it is important to understand what is real GDP.
GDP is expressed in two basic categories: Nominal GDP and Real GDP. To understand the values of each, it is important to understand how each category is calculated. Both types of GDP are calculated by the Bureau of Economic Analysis. This article focuses on explaining what is real GDP, as well as its advantages and disadvantages, and how it differs from the nominal GDP.
The Concept of Real GDP?
To answer the question of what is real GDP, it is important to understand that real GDP is the expression of the nation’s gross domestic product after factoring in the effects of inflation. In order to do this, the BEA implements a metric known as a “price deflator”.
Each quarter, as nominal GDP is reported, the BEA uses the price deflator in conjunction with a base year (2009 was the base year in 2016) to remove inflation from the index and allow for a more meaningful comparison of GDP over periods of time. The price deflator is the preferred tool for calculating real GDP, because it is the most objective. It does not place greater emphasis on any market sector, and it automatically accounts for changes in such factors as consumer buying habits and the introduction of new market segments.
By calculating real GDP, the Bureau of Economic Analysis accomplishes the following three goals:
- Revenue from persons and companies outside of the United States are excluded, thus removing any effects of trade policies and exchange rates.
- Any effects of inflation are removed.
- The value of goods reported is that for final products only. For example, buttons and bows on a garment are not counted.
The base year used by the BEA can be found in the Federal Reserve’s Table 1.1.6. Real Gross Domestic Product-Chained Dollars.
Calculating what is real GDP allows the BEA to better measure the country’s GDP growth. Since real GDP is calculated quarterly, a better picture of the nation’s economic health can be determined. These numbers are closely watched by investors, financial and economic analysts, and the Federal Open Market Committee. When growth seems to be outpacing the economy, the FOMC may choose to increase the fed funds target rate.
Advantages and Disadvantages of Focusing on Real GDP
While analysts and investors watch real GDP as reported quarterly, there is another form of GDP known as nominal GDP. When answering the question of what is the difference between real GDP and nominal GDP, nominal GDP is “raw” GDP, in that it only reports the base data without adjusting for anything else.
One reason for the real GDP preference is the instability that inflation brings to the raw data of nominal GDP. Inflation can skew the numbers when looking for true value in the manufacturing output of the nation.
Recommended read: What is GDP?
Advantages of Real GDP
Many economists prefer to use the Bureau of Economic Analysis’ quarterly calculation of real GDP in order to derive comparisons to that of nominal GDP reported monthly. Real GDP is always lower than nominal GDP, and provides a clearer picture of what is truly happening in the economy.
The Federal Reserve uses real GDP to compare actual growth rates along with other pertinent data, such as the Consumer Price Index and Unemployment Rate to determine the economy’s level of inflation and determine whether a change in interest rates or Fed Funds is in order. Therefore, investors who are trying to anticipate a possible interest rate hike usually prefer to track real GDP as well.
Another answer to the question of what is the difference between real GDP and nominal GDP is that of how the two indices are used. Because real GDP is calculated net of inflation, any changes noted in real GDP across comparative quarters will be a direct reflection of actual output. It will not be affected or influenced by price changes caused by inflation. If nominal GDP were used in these comparisons, it would not be clear whether an increase in the index was caused by increased production or increased prices of produced output.
Another advantage of real GDP is that it provides a more accurate representation of true output growth, which is an important item of consideration for policymakers in making decisions relative to such things as taxation and growth. It also helps financial institutions such as commercial banks in making asset management decisions. If real GDP reveals an economy that may be heating up too quickly, the Federal Reserve could raise interest rates, substantially affecting commercial banks’ ability to make new loans.
Disadvantages of Real GDP
Real GDP is best used when looking for a true “apples-to-apples” comparison in output over a span of more than one year. It looks for a quantitative analysis of the volume of products and services that are being generated in order to compare the data with previous years to identify a trend.
Real GDP does not attempt to show whether more money is changing hands as a result of the products and services being generated. It looks for volume.
Nominal GDP is used to track the total value of products and services produced within the country over a particular year. It can include increase in pricing due to inflation, but it is a gauge that is quite useful for investors and other analysts who want to see how the economy is tracking on a month-to-month basis.
Nominal GDP provides information as to how much money is being generated, regardless of inflationary influences. Therefore, a rise in nominal GDP, as reported monthly, shows an increase or decrease in dollar value of goods and services sold. This information alone may or may not influence investment activity such as trading in the stock market, but coupled with such indicators as the unemployment rate and fluctuations in commodities such as oil, the indicator can be an important source of information.
When looking to track economic activity from month-to-month within the current year, nominal GDP should be tracked rather than real GDP. Nominal GDP reflects current prices without having inflation factored out.
It is always a good idea to keep in mind that nominal GDP is higher than what is real GDP. This is why it is important to always compare nominal-to-nominal and real-to-real.
Gross Domestic Product (GDP) is an important economic indicator that provides a wealth of information as to the nation’s manufacturing productivity, economic growth, and inflation. In addition to real GDP and nominal GDP, additional types of GDP also help portray the economic health of the country. These types may include:
- GDP (E) – calculated using the expenditure approach;
- GDP (I) – calculated using the income approach;
However, when looking to gauge the economic productivity for a given period of time, most experts rely on either the real or nominal GDP index. Knowing what is real GDP helps in distinguishing between the two, and choosing the right tools for a particular purpose.