Real Gross Domestic Product

Real Gross Domestic Product (Real GDP) is a modification of the basic Gross Domestic Product (GDP) 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:While GDP is an important economic measure to use a deficiency in using GDP alone is that it does not reflect the impact of inflation on the economy being considered.
This impact can be significant particularly when considered over multi-year periods.

To factor inflation into Real GDP the following formula is typically used:The importance of establishing a baseline year in calculating GDP is that when factoring inflation in you need to use a starting point, and from there see the inflation impact since the baseline year chosen. For some studies a baseline year that is 5-10 years before the year being studied may be used (so choosing 2004 for a 2014 study) though year over year comparisons are common also (so choosing 2013 for a 2014 study).

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 GDP

So 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

Copyrighted 2016. Content published with author's permission.

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