# Focus on Economic Data: Gross Domestic Product - September 2002

### STUDENT'S VERSION

Announcement

Real Gross Domestic Product (GDP) during the second quarter (April through June) of 2002 increased at an annual rate of 1.3 percent. This is the final release of the number and was revised upward from the preliminary rate of 1.1% released on August 29. This compares to a rate of 5.0% in the first quarter of 2002. During 2001, real GDP changed at annual rates of -.6 percent, -1.6 percent, -.3 percent and +2.7 percent for each quarter respectively.

The growth rate in real GDP for all of 2001 was .3 percent. That compares to 4.1 percent annual growth rates in 1999 and 3.8 percent in 2000.

The revisions of the original announcement are small and due to slight increases in the estimate of exports along with slight decreases in the estimate of imports. These revisions were partially offset by a decrease in the estimate of inventory investment.

Attention Teachers

Material that appears in italics is included in the teacher version only. Everything else appears in the student version. Throughout the semester, the GDP cases will become progressively more comprehensive and advanced.

Definition of Gross Domestic Product

Gross Domestic Product (GDP) is one measure of economic activity, the total amount of goods and services produced in the United States in a year. It is calculated by adding together the market values of all of the final goods and services produced in a year.

• It is a gross measurement because it includes the total amount of goods and services produced, some of which are simply replacing goods that have depreciated or have worn out.
• It is domestic production because it includes only goods and services produced within the U.S.
• It measures current production because it includes only what was produced during the year.
• It is a measurement of the final goods produced because it does not include the value of a good when sold by a producer, again when sold by the distributor, and once more when sold by the retailer to the final customer. We count only the final sale.

Changes in GDP from one year to the next reflect changes in the output of goods and services and changes in their prices. To provide a better understanding of what actually is occurring in the economy, real GDP is also calculated. In fact, these changes are more meaningful, as the changes in real GDP show what has actually happened to the quantities of goods and services, independent of changes in prices.

Why are Changes in Real Gross Domestic Product Important?

The measurement of the production of goods and services produced each year permits us to evaluate our monetary and fiscal polices, our investment and saving patterns, the quality of our technological advances, and our material well-being. Changes in real GDP per capita provide our best measures of changes in our material standards of living.

While rates of inflation and unemployment and changes in our income distribution provide us additional measures of the successes and weaknesses of our economy, none is a more important indicator of our economy's health than rates of change in real GDP.

Changes in real GDP are discussed in the press and on the nightly news after every monthly announcement of the latest quarter's data or revision. This current increase in real GDP will be discussed in news reports as a sign that the economy may have already come out of the recession that began in March of last year.

Real GDP trends are prominently included in discussions of potential slowdowns and economic booms. They are featured in many discussions of trends in stock prices. Economic commentators use falls in real GDP as indicators of recessions. The most popular (although inaccurate) definition of a recession is at least two consecutive quarters of declining real GDP. See below for a discussion of the current recession.

Goals of Case Study

The goals of the GDP Case Studies are to provide teachers and students:

• access to easily understood, timely interpretations of monthly announcements of rates of change in real GDP and the accompanying related data in the U.S. economy;
• descriptions of major issues surrounding the data announcements;
• brief analyses of historical perspectives;
• questions and activities to use to reinforce and develop understanding of relevant concepts; and
• a list of publications and resources that may benefit classroom teachers and students interested in exploring inflation.

Data Trends

The growth in real GDP at the end of the 1990s has been relatively high when compared with the early part of the 1990s. However, during the last two quarters of 2000 and the first three quarters of 2001, the rate of growth of real gross domestic product slowed significantly as the U.S. economy entered a recession in March of 2001. During the three quarters of 2001, the changes in real GDP were actually negative for the first time since 1993.

The Federal Reserve has responded to slowing growth and the recession by reducing the target federal funds rate by 475 basis points (4.75%) from January 2001 to December 2001. (See Federal Reserve and Monetary Policy Cases.) The effects of stimulative monetary policy and the resulting low interest rates helped increase consumer spending over the past two quarters, partially responsible for the slight increase in real GDP in the fourth quarter of 2001 and the larger increase in the first quarter of 2002, continuing with the slight increase in the second quarter.

The price index for GDP increased at a rate of 1.2 percent during the second quarter of 2002, compared to an increase of 1.3 percent during the first quarter of 2002. It increased at an annual rate of 2.4 percent for 2001, compared to 2.1 percent for 2000.

The rate of increase in real GDP has been higher in the last several years than in the first part of the 1990s and much of the 1970s and 1980s. Economic growth, as measured by average annual changes in real GDP, was 4.4 percent in the 1960s. Average rates of growth decreased during the 1970s (3.3%), the 1980s (3.0%), and the first half of the 1990s (2.2%). In the last five years of the 1990s, the rate of growth in real GDP increased to 3.8 percent, with the last three years of the 1990s being at or over 4.1 percent per year.

The upward trend in economic growth over the past decade has been accompanied by increases in the rates of growth of consumption spending, investment spending, and exports. Productivity increases, expansions in the labor force, decreases in unemployment, and increases in the amount of capital have allowed real GDP to grow at the faster rates.

Details of the fourth-Quarter Changes in Real GDP

Real GDP increased at an annual rate of 1.3 percent in the second quarter of 2002 compared to a rise of 5.0 percent in the first quarter of 2002. Consumption continued to increase during the quarter, but at a slower rate than in the first quarter. State and local government spending actually declined, but federal spending on national defense increased substantially. Exports increased, but imports increased by an even larger amount with the net effect being a reduction in net exports.

For 2001, consumption spending increased at a rate of 2.5 percent, compared to 4.4 percent in 2000 and 4.9 percent in 1999.

Real investment increased at an annual rate of 7.9 percent during the second quarter of 2002, compared to an increase of 18.2 percent in the first quarter of 2002. The most important causes of the increase in the second quarter were a continued, but slowing, rise in residential investment and the increase in inventories. For all of 2001, investment spending decreased 10.7 percent.

Another cause of the increase in investment spending for the quarter was the difference in what happened to inventories in the second quarter when compared to the first quarter. The effects of the changes in inventories are not always easy to interpret. The previous quarter included a reduction in real inventories of almost \$29 billion. This quarter saw an increase in inventories of \$4.9 billion. Inventory reductions are counted as a negative investment - a reduction in the capital stock. What the increase in inventories during the second quarter really means is that businesses stockpiled goods to meet future anticipated increases in demand, as well as to meet the increased spending during the quarter (thus the increase in real GDP).

Exports increased by 14.3 percent (compared to an increase of 3.5 percent in the first quarter) and imports increased by 22.2 percent (compared to an increase of 8.5 percent in the fourth quarter). Thus net exports fell slightly during the quarter.

Recessions

On November 26, The National Bureau of Economic Research announced though its Business Cycle Dating Committee that it had determined that a peak in business activity occurred in March of 2001. That signals the official beginning of a recession.

The NBER defines a recession as a "significant decline in activity spread across the economy, lasting more than a few months, visible in industrial production, employment, real income, and wholesale-retail trade." The current data show a decline in employment, but not as large as in the previous recession. Real income growth has slowed but not declined. Manufacturing and trade sales and industrial production have both declined and have been doing so for some time.

As seen during this quarter, consumers are increasing their spending and businesses are increasing inventories. Government spending continues to increase and investment spending is increasing, all of which contribute to speculation that we are currently coming out of the recession. While it is not official, a consensus may be that the recession ended in December or January.

The last recession began in July of 1990 and ended in March of 1991, a period of eight months. However, the beginning of the recession was not announced until April of 1991 (after the recession had actually ended). The end of the recession was announced in December of 1992, almost 21 months later. One of the reasons the end of the recession was so difficult to determine was the economy did not grow very rapidly even after it came out a period of falling output and income.

For the full press release from the National Bureau of Economic Research see:
http://cycles-www.nber.org/cycles/november2001/recessnov.html

A Hint About News Reports

Many news reports simply use "gross domestic product" as a term to describe this announcement. The actual announcement focuses on the REAL gross domestic product, and that is the meaningful part of the report. In addition, newspapers will often refer to the rate of growth during the most recent quarter and will not always refer to the fact that it is reported at annual rates of change. This is contrasted to the reports of the consumer price index, which are reported at actual percentage changes in the index for a single month, and not at annual rates.

Explanations of GDP and its Components

It is common to see the following equation in economics textbooks:

 GDP = C + I + G + NX

Consumption spending (C) consists of consumer spending on goods and services. It is often divided into spending on durable goods, non-durable goods, and services. These purchases accounted for 70 percent of GDP in 2001

• Durable goods are items such as cars, furniture, and appliances, which are used for several years (10%).
• Non-durable goods are items such as food, clothing, and disposable products, which are used for only a short time period (20%).
• Services include rent paid on apartments (or estimated values for owner-occupied housing), airplane tickets, legal and medical advice or treatment, electricity and other utilities. Services are the fastest growing part of consumption spending (39%).

Investment spending (I) consists of non-residential fixed investment, residential investment, and inventory changes. Investment spending accounts for 17 percent of GDP, but varies significantly from year to year.

• Non-residential fixed investment is the creation of tools and equipment to use in the production of other goods and services. Examples are the building of factories, the production of new machines, and the manufacturing of computers for business use (14%).
• Residential investment is the building of a new homes or apartments (4%).
• Inventory changes consist of changes in the level of stocks of goods necessary for production and finished goods ready to be sold (-1%).

Government spending (G) consists of federal, state, and local government spending on goods and services such as research, roads, defense, schools, and police and fire departments. This spending (18%) does not include transfer payments such as Social Security, unemployment compensation, and welfare payments, which do not represent production of goods and services. Federal defense spending now accounts for approximately 4 percent of GDP. State and local spending on goods and services accounts for 12 percent of GDP.

Net Exports (NX) is equal to exports minus imports. Exports are items produced in the U.S. and purchased by foreigners (12%). Imports are items produced by foreigners and purchased by U.S. consumers (16%). Thus, net exports (exports minus imports) are negative, about -4% of the GDP. (For more information on the balance of trade, see the Trade Report case study.)

GDP as a Measure of Well-being

Changes in real GDP are a more accurate representation of meaningful economic growth than changes in nominal GDP, because changes in real GDP represent changes in quantities produced, while prices are held constant. Real GDP per capita is even more relevant because it measures goods and services produced per person and thus approximates the amount of goods and services each person can enjoy. If real GDP grows, but the population grows faster, then each person, on average, is actually worse off than the change in real GDP would indicate.

Consider the table below. While the mainland part of China has a GDP of \$991 billion, its GDP per capita is only \$791.30. Hong Kong has a much smaller GDP of \$159 billion. However, its GDP per capita is much higher at \$23,639.58. Other nations, such as France and Germany, may have quite different GDPs, but GDPs per capita that are very close.

 Country Population GDP (billions) Per Capita GDP China (Mainland) 1,262,460,000 \$1,158.70 \$910.80 China (Hong Kong) 6,797,000 \$161.87 \$23,879.50 France 58,892,000 \$1,307.06 \$21,988.90 Germany 82,150,000 \$1,847.35 \$22,427.10 United States 281,550,000 \$10,208.13 \$36,716.30

GDP per capita is not a perfect estimate of well-being. When individuals grow their own food, build their own houses and sew their own clothes, they are not producing goods and services to be sold in a marketplace and therefore GDP does not change. As a result, many countries South America and Africa have a low GDP per capita that underestimates their well-being.

(The comparisons in the above table are of nominal GDP per capita, not real GDP per capita. As we are comparing per capita figures for the same year there is no need to deflate the nominal figures into real figures.)

The U.S. as a Wealthy Country

Country   Percentage of Global GDP   Population   Percentage of World Population

Worldwide Gross Domestic Product
Estimates of 2001 GDP in billions of current US dollars

United States   32.9%   281,550,000   4.65%
Japan   13.4%   126,870,000   2.09%
Germany   6.0%   82,150,000   1.36%
United Kingdom   4.6%   59,739,000   0.99%
France   4.2%   58,892,000   0.97%
China   3.7%   1,262,460,000   20.84%
Italy   3.5%   57,690,000   0.95%
Canada   2.3%   30,750,000   0.51%
Mexico   2.0%   97,966,000   1.62%
Spain   1.9%   39,465,000   0.65%

An alternative way of comparing the size of world economies is to calculate the percentage of the world GDP (approximately \$32 trillion) produced in each country and compare that to the percentage of the world's population living in each country. As seen in the table above, the top ten countries in terms of gross domestic product comprise 75 percent of the global GDP with only 35 percent of the world’s population. The U.S. alone produces a third of the goods bought and sold around the world with only 4.7 percent of the world’s population. There are significant differences in the wealth of nations and the income of its citizens.

Revisions in GDP Announcements

Real GDP for each quarter is announced three times. The month following the end of the quarter is described as the advance GDP; the second announcement or revision is described as the preliminary announcement; and the third month is the final. While labeled as the final version, even it will eventually be revised after the final data for the year are published. Since 1978, the advance estimates have been revised an average increase of 0.5 percent in the rate of growth of GDP and the preliminary estimates have been revised by an average increase of 0.3 in the rate of growth of GDP.

Revisions in inventory investment and the international trade data are often the causes of changes in the GDP figures. Because changes in inventories and international trade data make up significant portions of the current report, one should be particularly cautious in using the “advance” and “preliminary” figures.

Questions

Components of GDP

Determine if each of the items listed below should be included in GDP and under which component or components: Consumption, Investment, Government, Exports or Imports.

1. A stereo produced and sold in the US by a Japanese company
2. College tuition
3. Social Security payments
4. Microsoft stock purchased from Microsoft
5. A space shuttle launch
6. The purchase of a plane ticket to London on British Airways
7. The purchase of a US Treasury Bond by an individual
8. A new factory
9. The sale of a previously occupied house
10. A bottle of French wine, sold in the US
11. A television produced, but not sold.
12. A home cooked meal
13. A dinner at a restaurant
14. A computer produced in the US and sold in Canada
15. A new interstate

Other Questions for Class Discussions

1. If gross domestic product increases by 10 percent over a year, are we better off? Why or why not?
2. If consumers begin to purchase automobiles manufactured abroad instead of those manufactured in the U.S., what will happen to real GDP?
3. Why are wages not included in gross domestic product?

Charts from this lesson