Economists track real gross domestic product (GDP) to determine the rate that an economy is growing without any of the distorting effects of inflation. The real GDP number allows them to measure growth more accurately.

Thus, there are two versions of GDP, the nominal GDP and the real GDP:

  • Nominal GDP, typically referred to as "just GDP," tracks the total value of goods and services produced in an economy in a given time period by calculating all their quantities and all their prices.
  • Real GDP tracks the total value of goods and services calculating the quantities but using constant prices.

Therefore, real GDP is a more accurate gauge of the change in production levels from one period to another, but nominal GDP is a better gauge of consumer purchasing power.

How GDP Is Calculated

The Bureau of Economic Analysis (BEA), a federal agency, calculates real GDP by removing the effects of inflation from the numbers using a GDP price deflator. The deflator is the difference in prices between the current year and the base year chosen by the BEA for comparison. For example, if prices rose by 5% since the base year, the deflator would be 1.05.

Key Takeaways

  • Nominal GDP is the total value of all goods and services produced in a given time period, usually quarterly or annually.
  • Real GDP is nominal GDP adjusted for inflation.
  • Real GDP is used to measure the actual growth of production without any distorting effects from inflation.

Nominal GDP is divided by this deflator, yielding real GDP. In times of inflation, the real GDP will be lower than the nominal GDP. In times of deflation, real GDP will be higher.

Real GDP may be reported as the "inflation-adjusted" or "constant dollar" GDP, while nominal GDP may be reported as the "current dollar" GDP. The BEA reports both figures in its quarterly and annual reports on GDP.

Why Real GDP Matters

The total amount that the economy is producing and consuming is important to track over time. It is a key indicator of the overall health and growth of the economy, and it is used to determine economic policy going forward.

For example, the Federal Reserve factors real GDP as well as the rate of inflation into its decisions on influencing the money supply.

In inflationary periods, real GDP will be lower than nominal GDP. In deflationary times, real GDP will be higher.

These decisions affect the entire economy. If real GDP growth is low or negative, the Federal Reserve may lower fund rates to boost business investment and consumer borrowing.

What Goes Into GDP

Both versions of the GDP number are estimates of the value of all the finished goods and services produced by the nation's economy during a given period. They include totals for consumer spending, business spending, government purchasing, and exports. Total imports are subtracted from the GDP number.

Some spending is not included in GDP. Sales of raw materials, sales of stocks and bonds, and government entitlement payments such as Social Security are excluded, as are sales of used goods and the value of volunteer services.