Real Gross Domestic ProductGDP) calculation that is commonly used to measure the size and growth of a country's economy. The modification performed is to adjust GDP to account for the impact of inflation in the country over a set period of time. GDP itself is calculated as:
- GDP = Consumption + Investment + Government Spending + Exports – Imports
To factor inflation into Real GDP the following formula is typically used:
- Real GDP = GDP / (1 + Inflation since base year)
Once establishing the base year you would divide GDP by your inflation adjuster, which as long as inflation was positive would result in a lower number than unadjusted GDP.
Relevance of Real GDPSo why bother factoring inflation into a GDP calculation?
The reason is that GDP is most commonly used to assess the economic health and growth of a country, typically for comparison to other countries and to compare to historical performance. However, from year to year and from country to country inflation can vary greatly and has a measurable impact on the economy.
If a country achieves a 5% growth rate in GDP, but inflation that year was 3%, is the country's economy really 5% higher. In a real dollar sense, yes, but in terms of an actual improvement, no. The country's real growth is 2% as that is the actual growth in the economy in terms of the purchasing power of individuals there.
Inflation can also have a major impact on multi-year comparisons. If the current year had a 6% growth rate in total GDP, and the prior year had a 5% growth in GDP, then from first glance it would appear the economy was growing faster. However, once inflation is factored in it could easily result in a real GDP growth rate that is lower if say inflation was 3% higher in the current year when compared to the last year.
As with the multi-year comparison when comparing different countries with different inflation rates it is important to adjust for inflation. In developing countries where inflation can be as high as 7% on a regular basis it can have a significant impact when comparing to a country with say a 1% inflation rate. Adjusting for inflation by using Real GDP figures is the only way to provide relevant comparison between the two countries. While using unadjusted GDP is not quite as bad as comparing apples to oranges it is still not a very appropriate comparison in terms of assessing performance.
By Jeffrey Glen