Economists use real gross domestic product (GDP) when they want to monitor the growth of output in an economy. Nominal GDP, typically referred to as just GDP, uses the quantities and prices in a given time period to track the total value produced in an economy over a certain time. Conversely, real GDP tracks the total value produced using constant prices, isolating the effect of price changes. As a result, real GDP is an accurate gauge of changes in the output level of an economy.
The Bureau of Economic Analysis (BEA) calculates real GDP by removing the effects of inflation from GDP using a GDP price deflator. The deflator is the difference in prices between the current year and 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. Nominal GDP is divided by this deflator, yielding real GDP.
Output growth is a key estimate for policymakers. For example, the Federal Reserve factors GDP into its decisions on influencing the money supply, and these decisions affect the entire economy. If GDP growth is low or negative, the fed funds rate is decreased, making it more difficult for banks to acquire capital. As a result, banks can make fewer loans to individuals and businesses, which slows down economic growth. This is an appropriate policy response when the economy is in a downturn, but nominal GDP cannot convey that information. Negative growth of nominal GDP may be due to a decrease in prices or a decrease in output, but negative growth of real GDP can only be due to a decrease in output. (For more, see: Nominal vs. Real GDP.)