Gross Domestic Product (GDP) is the most common measure used when it comes to assessing the economic status, health, and growth of a country. However, simply looking at GDP itself can be misleading in terms of the growth it can project from quarter to quarter or year to year. One adjustment to simply looking at GDP is to instead use Real GDP, which adjusts GDP for inflation in the country.
Inflation has a major impact on economies every year, with even low inflation countries typically seeing at least 1% every year.
Compounded over several years the impact of inflation can be staggering, representing billions of dollars in price increases that eat away at the actual dollar growth of the economy.
The importance of an inflation-adjusted GDP becomes even more important when you consider that countries can have drastically different inflation rates impacting their economy each year. While some countries see a 1% increase each year others consistently expect to see 5%, 6%, or even 7% annual inflation figures. If inflation is not adjusted for then the comparative GDP figures between two countries can be very misleading, as the higher inflation country has seen less real growth in the economy.
The first step in calculating Real GDP is to establish a base year from which you can then calculate the GDP deflator. Specifically, from this year you will take the unadjusted GDP amount, and then factor in inflation from every year since then. GDP itself is calculated as:
If for example, you wanted to calculate the 2010 Real GDP for a country using 2000 as a base year you would start by using the above formula to calculate GDP for both 2000 and 2010. The next step would be to use a GDP deflator on the 2010 figure to account for inflation over that ten-year period. If the total inflation over that ten year period was 10% and the GDP for 2010 that you calculated was $1.1 trillion the result would be:
So while the unadjusted GDP figure was $1.1 trillion, once you adjust that for inflation the Real GDP is $100 billion lower. This is a major adjustment and demonstrates the impact of calculating Real GDP as inflation alone can substantially skew a simple calculation of GDP over time. While the dollar value of GDP is correctly calculated at $1.1 trillion, inflation over a 10 year period has meant that $100 billion of that is taken away due to the reduced purchasing power within the country.
The mechanics of calculating GDP is far more complicated than the above formula simply suggests, something like consumption is difficult to quantify and the data very difficult to find. This is the main reason why GDP data for a quarter or a year comes out months after the actual quarter or year has ended. The background work is usually done by teams of economists reviewing substantial source data, and even then it’s an approximation (and is virtually impossible to do alone).
This is why different GDP figures are provided by different organizations, i.e. the International Monetary Fund will have different figures than the World Bank. When comparing GDP between countries or over time it’s important that you use the same source as at least then the same methodology is being used for all of the figures you are using.