GDP, or gross domestic product, is a measure of the goods and services produced in a country within a certain period of time. Real GDP adjusts for inflation or deflation within an economy, while Nominal GDP uses current prices. So, as follows:
- Real GDP uses a base year to adjust nominal GDP for inflation or deflation.
- Nominal GDP considers only the current prices
For sake of simplicity, let’s consider an economy that produces 10 cars worth $10 in 2024, 11 cars worth $10 in 2025, and 12 cars worth $10 in 2026. Inflation in those years were 6%, 10%, and 3%.
The nominal GDP in the economy could be calculated using any given GDP method, like the expenditure approach, income approach, or production approach. We can generalize the nominal GDP formula to multiplying the price of goods and services at a given time with the quantity of goods and services produced at a given time, equivalent to a simple P(Q) equation:
Nominal GDP = Pt*Qt
So, the nominal GDP of the economy we described goes as follows:
- 10 x $10 = $100 in 2024
- 11 x $11 = $121 in 2025
- 12 x $12= $144 in 2026
Let’s now look at the real GDP in 2026. Real GDP must be calculated either with a base year or a GDP deflator. A GDP deflator is a number that reflects how much GDP change comes from changes in the price level rather than changes in output. We won’t focus on GDP deflators for now — let’s instead look at a base year of 2024, and calculate the real GDP for 2026. The formula multiplies the price of goods and services in the base year by the quantity of goods and services produced in the year we’re calculating for.
Just think of this as using older prices and current quantity to calculate GDP through the lens of that base year. Since inflation in our economy was significant over the three year period, looking at those older prices for the same goods and services gives us an idea of what price differences came from inflation versus an actual increase in productive output of goods and services. As follows:
Real GDP = P(base) *Qt
- prices in base year multiplied by quantity sold; you MUST have base year prices and quantity sold in the period you’re calculating GDP for, for all goods and services produced, and match those up accordingly. For example, you need to know that a car was sold for $10 in 2024, and 12 cars were produced in 2026.
Let’s calculate real GDP for 2026 as described using 2024 as the base year:
- ($10 x 12) = $120
So, the real GDP in 2026 is $120, while the nominal GDP is $144. This means that roughly half of the “increase in the value” of output came from inflation, while the actual value (think of this like purchasing power) increase stripped of inflation was only about $20 from 2024 to 2026.
Here’s one more useful formula to know:
- GDP Deflator = nominal GDP/real GDP x 100
Like we said, the GDP deflator gives us a metric detailing how much of GDP increases are due to inflation versus output increases. Since we’ve now calculated both real and nominal GDP, we can run these numbers:
- Real GDP in 2026: $120
- Nominal GDP in 2026: $144
- GDP Deflator = 144/120 x 100 = 1.2 x 100 = 120
A GDP deflator of 120 infers that the current price level is 20% higher than the price level in the base year, or that inflation has been 20% over that three year period. If we look at the inflation numbers described earlier—6%, 10%, and 3%—1.06 × 1.10 × 1.03 happens to equal 1.20098, equivelant to exactly 20%.
So, that’s today’s guide on nominal versus real GDP! Let me know what other economic you’d like to read about, and here are some other articles in the meantime:
- Read about the Income Approach to GDP here.
- Read more economics stories here.
- Also, to learn more about the oil market, consider reading about PADD Districts, the Why WTI and Brent are Crude Oils, and Why There are Price Differences Among Crude Oils, and my Oil & Gas Terms Guide.
