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Real gross domestic product (real GDP) is a cornerstone metric used to assess the health of an economy. It measures the total market value of all goods and services produced in a country, adjusted for inflation to provide a clearer picture of actual economic growth. This guide simplifies real GDP, explaining its calculation, implications, and the factors that influence its ups and downs. By understanding real GDP, you’ll gain valuable insights into how economies expand and contract.
What is real GDP?
Real gross domestic product (real GDP) acts like a yardstick for measuring a nation’s economic health. It captures the total value of all final goods and services produced within a country’s borders in a given year. But unlike a simple price tag, real GDP goes a step further by factoring out inflation.
Imagine you’re tracking the annual output of a bakery. Their sales figures might increase due to rising bread prices, not because they’re actually baking more bread. Real GDP uses a constant set of prices (usually from a base year) to account for these inflation fluctuations. This allows us to see the true picture: is the bakery churning out more loaves, or is the price of bread simply going up?
In essence, real GDP helps us understand the actual growth of an economy’s productive capacity, not just changes caused by inflation. By focusing on real GDP, we gain a clearer understanding of a country’s economic well-being and its ability to generate goods and services.
How to calculate real GDP
Understanding how real GDP is calculated is key to interpreting its meaning. Here’s a breakdown of the formula:
Real GDP = Quantity produced in year (t) x Price of base year
- Quantity produced in year (t): This represents the total amount of goods and services produced in a specific year (denoted by “t”).
- Price of the base year: This refers to the market prices of goods and services in a chosen base year. The base year serves as a benchmark, and its prices are used consistently throughout calculations for different years.
By multiplying the quantity produced in a given year by the constant prices of the base year, we effectively remove the distorting effects of inflation. This allows us to compare the true changes in production across different years.
For instance, if a country produces 100 units of a good in 2023 and 120 units in 2024, a simple comparison of their market values might be misleading due to potential inflation. However, calculating real GDP using the base year’s price eliminates this inflation bias and reveals the actual increase in production (20 units) between the two years.
Therefore, the year-to-year change in real GDP reflects the genuine growth or decline in a nation’s economic output, independent of price fluctuations.
Real GDP growth and its implications
GDP is one of the most widely cited economic indicators. Analysts, policymakers, and researchers monitor it, and its change gives valuable insight into how an economy grows and develops.
Usually, real GDP growth will follow the up and down phases, which we call a business cycle. A positive in its growth indicates an expanding economy. Conversely, negative growth means an economic contraction.
A business cycle occurs because the real GDP deviates from its potential, which can be lower or higher. A lower real GDP than its potential means the economy underutilizing its production capacity, leading to downward pressure on the general price. Economists call this phenomenon a contractionary gap.
Conversely, when real GDP is above its potential, upward pressures on general prices emerge, and the economy becomes overheated. This condition typically causes a trade deficit. Why trade deficit? Because aggregate demand exceeds domestic supply, hence, the country must import from abroad.
When real GDP growth falls
A decline in real GDP growth shows economic contraction. If it occurs for two consecutive quarters, it is a recession. A severe recession refers to depression.
A contraction leads to a higher unemployment rate. The inflation rate slows down or is even negative (deflation).
Economic activity declines during a recession. Demand for goods and services falls, forcing businesses to cut production and rationalize their production costs. Companies are starting to stop hiring new workers or even lay off existing workers to maintain efficiency.
Weaker demand and excess capacity drive down the general price level.
To avoid a deep recession, governments then adopt expansionary policies using fiscal or monetary tools. For instance, the government (in this case, the central bank as its representation) opts to cut policy rates. A lower policy rate increases the money supply and liquidity in the economy, driving down lending rates.
Because households could get a new loan at a lower cost, they are eager to spend more on goods and services. At the same time, businesses are interested in taking out loans to finance capital investment. As a result, aggregate demand increases, encouraging producers to raise their output and hire more workers. Overall, the policy livens up economic activities.
Lower interest rates will drive up bond prices in the capital market. Because bond yield is negatively correlated with prices, it will decline following the interest rate cut.
When real GDP growth rises
The positive growth of real GDP indicates an expansion. When it grows at a healthy level, the unemployment rate will fall, and inflation will increase moderately. But when its pace is too fast (economic boom), inflationary pressures build up. High inflation harms the economy as it undermines money’s purchasing power.
During a steady growth, aggregate demand increases. It leads businesses to increase production and hire more workers as they see improved profitability prospects.
In the capital market, stock prices move up, particularly for cyclical companies. During expansion, these companies usually have better profit prospects than defensive companies. Hence, investors will collect their stocks.
When demand growth strengthens, businesses are confident to raise their selling prices. It pulls inflation up.
Rising inflation undermines workers’ nominal wages and weakens their purchasing power. This situation forces them to renegotiate nominal wages to offset the decline in purchasing power. An increase in wages increases the cost of production, encouraging companies to pass it on to higher selling prices. As a result, inflationary pressures are getting higher, causing the economy to overheat.
To avoid the adverse effects, the central bank would raise interest rates to curb it. Higher lending rates make new loans more expensive and reduce aggregate demand in the economy. As a result, economic growth began to cool down.
How real GDP differs from nominal GDP
Real GDP is a better indicator of economic growth than nominal GDP. It is measured at constant prices, while nominal GDP is at current prices. Consequently, nominal GDP will change as a combination of price changes and output quantity changes. In contrast, since real GDP uses constant prices, it removes price effects, so its fluctuation reflects changes in the quantity of output.
Let’s take a simple example. Suppose a country produces 10 tons of good X at a price of US$20 per ton in 2017. Then, in 2018, output increased to 15 tons, and the price rose to US$22 per ton. Assuming 2017 is a base year, we calculate GDP numbers as follows:
- Nominal GDP in 2017 = US$20 x 10 = US$200 and in 2018 = US$22 x 15 = US$330
- Real GDP in 2017 = US$20 x 10 = US$200 and in 2018 = US$20 x 15 = US$300
Nominal GDP will always be equal to real GDP in the base year. In 2018, nominal GDP growth is equal to 65% = [(US$330/US$200) – 1] x 100%. But, real GDP only grows 50% = [(US$300/US$200) – 1] x 100%; which is equivalently to the increase in the output, that is 50% = [(15/10) – 1] x 100%.
Nominal GDP in 2018 is higher because the price of good X also rises simultaneously, from US$20 to US$22 or 10% = [(US$22/US$20) -1] x 100% (implicit price deflator). To calculate real GDP from nominal GDP, we must deduct the nominal value with a deflator, which is US$330/(1 + 10%) = US$300.
Then, what is the nominal GDP for? The answer is that we use it to describe the economic size of a country because it uses current market prices.
Determinants of Real GDP
Many factors affect the GDP at a constant price. Breaking down GDP components, particularly from the expenditure approach, is a good starting point for analysis.
In this section, we summarize several factors that affect real GDP.
- Household income and wealth. Higher incomes encourage consumers to spend more money on goods and services, stimulating businesses to increase production.
- Fiscal policy. Governments influence economic growth by using budgetary instruments such as government spending and taxes. Lower personal tax rates, for example, give consumers more money to spend on goods and services.
- Monetary policy. Central banks stimulate aggregate output and prices by manipulating the money supply. An increase in the money supply, for instance, by lowering interest rates, results in increased consumption and investment.
- Exchange rate. Currency depreciation makes domestic goods cheaper for foreigners. It should spur exports as they become more competitive in the international market
- Global economic growth. Strong global economic growth increases the demand for domestic goods. It should lead to increased exports and GDP.
- Business confidence. Businesses increase investment spending when they are optimistic about future profits. It should drive aggregate output and GDP higher.
- Consumer confidence. When consumers feel confident about their future income and job stability, they tend to spend a higher proportion of their income on the consumption of goods and services.
- Capacity utilization. When capacity utilization is low, businesses can expand output by increasing their current plant capacity utilization.
- Input price. Lower wages and raw material prices reduce production costs and increase businesses’ profit margins, encouraging them to raise production.
- Business taxes and subsidies. Lower business taxes and higher subsidies reduce production costs and result in an increase in GDP.
- Technology. It increases labor productivity by enabling workers to produce more goods and services with the same resources.
