GDP, which stands for gross domestic product, is one of the most-used and important statistics in determining the strength or weakness of a national economy. It is calculated by adding the value of all of the goods produced and services rendered in a national economy. GDP is an important factor in shaping Federal Reserve policy. Real and nominal are two different calculations of the GDP.
Price levels are an important part of the GDP calculation. For instance if a factory makes 1,000 widgets at $5 a widget, that adds $5,000 to the total GDP. But if the widget costs just $4, just $4,000 would be added to the total even though the exact same number were produced. Economists factor in price levels when comparing GDP across the years.
Nominal GDP is not adjusted for changes in price levels. It uses the prices that were in place from the year in which the GDP is calculated. It doesn't take into consideration inflation or deflation but is just a snapshot of the goods and services produced at prevailing prices for that quarter or year.
Real GDP is a way for economists to compare figures across years or decades. It strips out inflation and deflation to allow one year's GDP to be compared to another. That allows an apples-to-apples comparison in which prices are constant in each GDP figure.
To understand the difference between real and nominal GDP, one must also grasp inflation and deflation. Inflation is when prices increase, leading to a reduction in purchasing power of a currency unit. Deflation is when prices fall, leading to a currency having more pricing power. Over time there tends to be a few percentage points a year of inflation even in a healthy economy, which is why GDP needs to be adjusted to allow meaningful (or "real") comparisons.
Calculating Real GDP
To adjust nominal GDP into real GDP, economists first create an index that measures the price of goods and services from one year compared with another. That price index is used to lower nominal GDP when prices rise and increase nominal GDP when prices fall. Here is the equation that is used: Real Gross Domestic Product (GDP) = (Nominal GDP/Price Index) * 100.
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