Real gross domestic product (real GDP) is the market value of all goods and services produced in the economy, measured at constant prices. Its growth represents a change in the aggregate output; hence economists use it as an economic growth indicator. Also known as GDP at a constant price.
Real GDP calculations use market prices in the base year. The formula is as follows:
Real GDP = Quantity produced in yeart x Price of base year
Because it uses constant prices, the year-to-year change of real GDP reflects changes in the quantity of output. When production rises, it increases. Conversely, if production falls, its value decreases.
Real GDP growth and its implications
GDP is one of the most-widely-cited economic indicators. It is monitored by analysts, policymakers, and researchers. 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 it as 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 as 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 it falls
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, they will 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 eagers 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 to hire more workers. Overall, the policy livens up economic activities.
In the capital market, lower interest rates will drive up bond prices. And, because bond yield is negatively correlated with prices, it will decline following the interest rate cut.
When it rises
The positive growth of real GDP indicates an expansion. When it grows at a healthy level, the unemployment rate will fall, and inflation increases 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 to 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.
For workers, rising inflation undermines their 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 to 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 using constant prices, real GDP take out 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 increases to 15 tons, and the price rises 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.
What factors affect real GDP?
Many factors affect the GDP at constant price. A good start for analysis is by breaking down GDP components, particularly from the aggregate demand approach.
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, make consumers have 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 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 margin. It encourages 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.