# How to Calculate Real GDP Growth Rates

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• 0:05 Real GDP Growth Rates
• 1:29 GDP Growth Rate Formula
• 5:25 Conclusions About the Economy
• 6:16 Nominal GDP
• 6:56 Real GDP
• 7:46 Lesson Summary
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Lesson Transcript
Instructor: Jon Nash

Jon has taught Economics and Finance and has an MBA in Finance

How can you tell how much the economy is really growing from year to year? In this lesson, you'll discover the formulas economists use to calculate real GDP growth rates and draw conclusions about real economic growth.

## Real GDP Growth Rates

Let's talk about real GDP growth rates and then look at two examples.

GDP growth rates are kind of like the speedometer on a sports car. Just imagine that Bob, from the town of Ceelo, has done quite well in his lawn business. He just left the mall, where he bought some new designer jeans, and he's driving a new sports car, let's say. The speedometer on Bob's car is going to show how fast he's going at any given time. Now, let's say that Bob is on the city street, where he's traveling at 40 miles an hour. Well, then he enters the expressway, where his speed increases to 60 miles per hour.

When Bob went from the city street to the expressway, he accelerated from 40 mph to 60 mph, which is a 50% increase. Economists basically talk about the same thing when they calculate nominal GDP growth rates to determine how fast the economy accelerated or slowed. Nominal GDP growth measures the actual growth rate from one year to the next. The only major difference is that instead of the 50% rates you can get by using a car as an example, you tend to get much smaller growth rates for major economies, like 2% or 6%.

## GDP Growth Rate Formula

In order to calculate the growth rate of nominal GDP, we need two nominal numbers in two different years, year 1 and year 2. Here's the formula for calculating GDP growth rates:

(GDP in year 2 / GDP in year 1) - 1

For example, let's suppose that in year 1, which is our base year, the total production in the economy was \$16,000. That's our nominal GDP, and it represents current production at current prices. In year 2, the total production (or nominal GDP) was \$16,820. So we see that production went up. By how much? Well, let's calculate the growth rate of nominal GDP. When you do the numbers, it works out like this:

(\$16,820 / \$16,000) - 1, which equals 5.1%. That means from year 1 to year 2, nominal GDP in this economy of two goods has increased by 5.1%.

Now imagine that Bob is on the expressway, but it's totally covered with ice. Have you ever driven a car on ice during the wintertime in a cold place? I know I have! Bob's speedometer says he's going 60 miles per hour, but a police radar gun (like the ones they use during the baseball games) says that he's only going 40 miles per hour. When you're trying to go fast on the ice, your tires are doing some spinning underneath you as you drive. The ice is very slippery, and the car tires don't have the same amount of traction on the ice as they do on the regular pavement during summertime, let's say.

Economists recognize that some of the increase in nominal GDP may have been due to a sustained increase in prices, which we call inflation. Inflation is a lot like driving on ice. It makes you feel like you're just spinning your wheels - and hey, let's hope you're not on thin ice! When you think the economy is growing by 6%, it may really be only growing by 3% after inflation.

Inflation subtracts from nominal GDP growth. For this reason, we use real GDP growth rates to remove the effects of rising prices. This process will allow us to draw some conclusions afterwards, and it's what helps fiscal policy leaders and monetary policy leaders interpret the trends in the economy so they can create policies that will promote economic growth.

Nominal GDP growth is like the speedometer in the car when you're driving on ice. It says that you're going faster than you really are. On the other hand, real GDP growth is like the radar gun held by the police, and it measures how fast you're really going. I mean, come on, let's be real. Keepin' it real in Ceelo! Hey, that was a Top 20 radio hit last year, I think.

Good news! We can use the same formula to calculate both nominal and real GDP growth rates. The formula is:

(GDP in year 2 / GDP in year 1) - 1

Let's say that in year 1, which is the base year, real GDP was \$16,000. In year 2, real GDP was \$16,400. Now we can calculate the growth rate in real GDP because we have two years of data. The growth rate is simply (\$16,400 / \$16,000) - 1 = 2.5%.

Okay, it's time to draw some important conclusions about the economy. Using the examples that we used here, nominal GDP increased. By how much? 5.1%. Real GDP increased as well. How much did it increase? By 2.5%.

So what initially looks like a 5.1% growth in the economy really turns out to be only 2.5% growth after you factor in the effect of inflation (or the increase in prices between these two years). Hey, if you're driving on ice, you can't always trust the speedometer. See what the radar gun says. That's what real GDP is all about. Did the economy really grow?

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