Real Gross Domestic Product (Real GDP) is a modification of the basic Gross Domestic Product (GDP) calculation that is commonly used to measure the size and growth of a country’s economy. The modification performed is to adjust GDP to account for the impact of inflation in the country over a set period of time. GDP itself is calculated as:
While GDP is an important economic measure to use a deficiency in using GDP alone is that it does not reflect the impact of inflation on the economy being considered.
This impact can be significant particularly when considered over multi-year periods.
To factor inflation into Real GDP the following formula is typically used:
The importance of establishing a baseline year in calculating GDP is that when factoring inflation in you need to use a starting point, and from there see the inflation impact since the baseline year chosen. For some studies, a baseline year that is 5-10 years before the year being studied may be used (so choosing 2004 for a 2014 study) though year over year comparisons are common also (so choosing 2013 for a 2014 study).
Once establishing the base year you would divide GDP by your inflation adjuster, which as long as inflation was positive would result in a lower number than unadjusted GDP.
So why bother factoring inflation into a GDP calculation?
The reason is that GDP is most commonly used to assess the economic health and growth of a country, typically for comparison to other countries and to compare to historical performance. However, from year to year and from country to country inflation can vary greatly and has a measurable impact on the economy.
If a country achieves a 5% growth rate in GDP, but inflation that year was 3%, is the country’s economy really 5% higher. In a real dollar sense, yes, but in terms of an actual improvement, no. The country’s real growth is 2% as that is the actual growth in the economy in terms of the purchasing power of individuals there.
Inflation can also have a major impact on multi-year comparisons. If the current year had a 6% growth rate in total GDP, and the prior year had a 5% growth in GDP, then from first glance it would appear the economy was growing faster. However, once inflation is factored in it could easily result in a real GDP growth rate that is lower if say inflation was 3% higher in the current year when compared to the last year.
As with the multi-year comparison when comparing different countries with different inflation rates it is important to adjust for inflation. In developing countries where inflation can be as high as 7% on a regular basis, it can have a significant impact when compared to a country with say a 1% inflation rate. Adjusting for inflation by using Real GDP figures is the only way to provide a relevant comparison between the two countries. While using unadjusted GDP is not quite as bad as comparing apples to oranges it is still not a very appropriate comparison in terms of assessing performance.