Measurement of economic growth: real Gross Domestic Product (GDP)

Measurement of Economic Growth: Real Gross Domestic Product (GDP)

1. What is GDP?

Gross Domestic Product (GDP) is the total market value of all final goods and services produced within a country’s borders in a given period (usually one year).

2. Why use Real GDP instead of Nominal GDP?

• Nominal GDP is measured at current market prices, so it is affected by changes in both output and price levels.
• Real GDP removes the effect of inflation (or deflation) by valuing output at constant (base‑year) prices, allowing a pure comparison of physical output over time.
• Real GDP therefore provides a more accurate indicator of economic growth.

3. Calculating Real GDP

The most common method is the expenditure approach adjusted for price changes using a price index.

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\text{Real GDP}t = \frac{\text{Nominal GDP}t}{\text{GDP Deflator}_t}\times 100

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where the GDP Deflator is a broad price index that reflects the average price level of all goods and services included in GDP.

4. The GDP Deflator

The GDP Deflator for year t is calculated as:

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\text{GDP Deflator}t = \frac{\text{Nominal GDP}t}{\text{Real GDP}_t}\times 100

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It differs from the Consumer Price Index (CPI) because it includes prices of investment goods, government services and net exports, not just consumer goods.

5. Example Calculation

Suppose the following data for Country X:

Real GDP for each year is:

1. 2015: \$\text{Real GDP}_{2015}= \frac{1,200}{110}\times100 = 1,091\text{ (US\$ billions)}
2. 2020: \$\text{Real GDP}_{2020}= \frac{1,500}{125}\times100 = 1,200\text{ (US\$ billions)}

Growth in real output between 2015 and 2020:

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\text{Growth Rate} = \frac{1,200-1,091}{1,091}\times100 \approx 10.0\%

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6. Interpreting Real GDP Growth

• Positive growth indicates an expanding economy and usually higher employment.
• Negative growth (recession) signals a contraction, often accompanied by rising unemployment.
• Very high growth rates may be unsustainable if they lead to overheating and inflation.

7. Limitations of Real GDP as a Measure of Economic Growth

• Does not account for the distribution of income – growth may benefit only a small segment of the population.
• Excludes non‑market activities such as household work and volunteer services.
• Ignores environmental degradation and depletion of natural resources.
• Quality improvements and new products may be under‑recorded if they are not reflected in price changes.
• Relies on accurate price indices; errors in the deflator can distort real GDP estimates.

8. Suggested Diagram

9. Summary Checklist

• Understand the definition of GDP and why we need a “real” measure.
• Know the formula: \$\text{Real GDP} = \frac{\text{Nominal GDP}}{\text{GDP Deflator}}\times100\$.
• Be able to calculate the GDP deflator and use it to convert nominal to real values.
• Interpret growth rates and recognise the main limitations of real GDP.