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Gross domestic product (or "GDP") is one of the most important, poorly understood parts of political debate.

This is what economists refer to when they talk about the size of an economy. It's what politicians refer to when they talk about economic growth. Depending on who you talk to, it's either the cornerstone of modern policy or a grossly overrated figure.

Here's what you need to know about real GDP.

What Is GDP?

Gross Domestic Product measures the total output of all the goods and services in an economy as measured by the price of those products. Typically GDP is expressed in U.S. dollars, the world's standard reserve currency, however, economists can measure GDP in any currency they choose.

For example, take a sample economy with the following outputs:

  • A bakery which sells loaves of bread for $10 a loaf and bakes 20 loaves a year;
  • A law firm which bills at $50 an hour and does 100 hours of business a year;
  • A carpenter who sells chairs for $25 a chair and builds 10 chairs per year;
  • A school that employs two teachers for $1,000 a year (the price per year of education).

If we assume that this represents the total of all work and production in our make-believe economy, it has the following GDP:

• ($10 x 20) + ($50 x 100) + ($25 x 10) + ($1,000 x 2) = $7,450

The total amount of goods, services and work produced by this economy, otherwise known as its size, is $7,450.

Services

Gross domestic product also includes services and government-produced value. Service outputs are businesses that charge for time or labor rather than a per-unit product, such as lawyers, doctors, plumbers, electricians. The GDP typically (although not always) measures them based on revenue.

It also measures many forms of government work such as teaching or military services. This is typically calculated based on the salaries paid to those service providers given that they create value (protection and education create real, tangible benefits to consumers, for example) but don't directly charge consumers for that product. (Citizens pay for government services through taxes, but since not all tax dollars create value, it would be inaccurate to include the government's tax base in the GDP.)

Finished Products

Note that gross domestic product only measures final products sold to consumers. It does not include components or intermediate products. For example, in our study above, GDP would not measure the value of the lumber sold to the carpenter.

This is to avoid double-counting the same product.

What Is Real GDP?

Real GDP is a measure of gross domestic product that adjusts for inflation and deflation. This is as opposed to nominal GDP which measures gross domestic product based on unadjusted prices.

Inflation/Deflation

Inflation and deflation are the processes of prices changing on the same product from year to year either up or down respectively. For example, take a loaf of bread that costs $10 in 2019. If that same loaf of bread costs $11 in 2020 it has experienced inflation of 10%. If that bread, on the other hand, costs $9 in 2020 it has experienced deflation of 10%.

Deflation happens rarely in modern economies. Most experience annual rates of inflation, as prices go up due to increased access to cash and purchasing power by consumers.

Real GDP vs. Nominal GDP

Real GDP generally measures an economy's actual value more accurately than nominal GDP.

Nominal GDP measures the total output of an economy based only on prices. This means that the metric will increase both with economic output and also price inflation. For example, consider the bakery in our sample economy above. Under a measure of nominal GDP we might have two situations:

  • The bakery produces 20 loaves of bread in 2019 then 22 loaves of bread in 2020. It charges $10 a loaf both years.
  • OR the bakery charges $10 a loaf in 2019 then $11 for the same loaf in 2020. It produces 20 loaves of bread both years.

In both cases nominal GDP would grow by 10% (from $200 per year to $220). However in the second case that growth would be illusory. It wouldn't represent an economy generating more goods and services, just an economy charging more for the same ones.

By accounting for inflation or deflation, real GDP will only grow when an economy actually produces more and/or more valuable outputs. In our case above, for example, real GDP would show growth in the first situation but not in the second.

Using Nominal GDP

While real GDP measures an economy more accurately, economists use nominal GDP to measure an economy against factors that don't change with inflation. The most common example of this is debt. National debt has an interest rate but it doesn't necessarily change with inflation. As a result, economists usually measure a nation's debt-to-GDP ratio based on nominal GDP.

How to Calculate Real GDP

Real GDP is calculated by the following formula: Real GDP = Nominal GDP / Deflator.

The deflator is a figure produced based on the rate of inflation. For example, say the national rate of inflation was 2% in a given year (indicating that the same goods and services cost an average of 2% more than they did the year before). In this case, the deflator will be 1.02.

For example, say an economy has a nominal GDP of $100 million, the raw total of all goods and services as measured by their prices. Assume also that the economy has experienced 2% inflation over the course of the year. We would calculate real GDP as:

  • 100 million / 1.02 = 98.03 million

After accounting for inflation, the economy actually produced approximately $98 million worth of goods and services.

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