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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Constant-Price GDP

What it is:

Also called real GDP, constant-price gross domestic product (GDP) is inflation-adjusted GDP.

How it works (Example):

Gross domestic product (GDP) is the broadest quantitative measure of a nation's total economic activity. More specifically, GDP represents the monetary value of all goods and services produced within a nation's geographic borders over a specified period of time.

The Department of Commerce releases GDP data for the U.S. economy on a quarterly basis at 8:30 am EST on the last business day of the next quarter.

The equation that's used to calculate GDP is as follows:

GDP = Consumption + Government Expenditures + Investment + Exports - Imports

The components that are used to calculate GDP include:

Consumption:

  • Durable goods (items expected to last more than three years)
  • Nondurable goods (food and clothing)
  • Services

Government Expenditures:

  • Defense
  • Roads
  • Schools

Investment Spending:

  • Nonresidential (spending on plants and equipment), residential (single-family and multi-family homes)
  • Business inventories

Net Exports:

  • Exports are added to GDP
  • Imports are deducted from GDP

The GDP report also includes information regarding inflation:

  • The implicit price deflator measures changes in prices and spending patterns.
  • The fixed-weight price deflator measures price changes for a fixed basket of more than 5,000 goods and services.

Inflation, however, changes the value of money over time. Accordingly, constant-price GDP measures the value of a country's goods and services in relation to a base year.

For example, let's say we want to measure the real GDP of Country A. In 2000, the country produces $55 of goods and services. If we set 2000 as the base year, any future GDP is measured against that total. For example, let's assume that in 2001, Country A's GDP produces the same amount of goods and services but now the price of them is $78 because of inflation. Though GDP is now $78, the constant-price GDP is still $55 -- it takes out the effects of inflation.

Why it Matters:

GDP is calculated both in current dollars and in constant dollars. Constant-price GDP involves calculating economic activity in present-day dollars. This, however, makes time period comparisons difficult because of the effects of inflation. By comparison, constant-price GDP factors out the impact of inflation and allows for easy comparisons by converting the value of the dollar in other time periods to present-day dollars.

When GDP declines for two consecutive quarters or more, by definition the economy is in a recession. Meanwhile, when GDP grows too quickly and fears of inflation arise, the Federal Reserve often attempts to stimulate the economy by raising interest rates.

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