# Focus on Economic Data: U.S. Gross Domestic Product - June 29, 2006

### STUDENT'S VERSION

Announcement

Real Gross Domestic Product (GDP) during the first quarter (January, February, and March) of 2006 increased at an annual rate of 5.6 percent. This is the third estimate of the rate of change for the first quarter.

This quarter's increase compares to annual rates of 4.1 and 1.7 percent in each of the two previous quarters. For the entire 2005 year, real GDP increased at a rate of 3.5 percent. Annual growth rates in 2002, 2003, and 2004 were 1.6, 2.7, and 4.2 percent.

Quarterly growth at annual rates

Rates of change in GDP figures are reported for years and quarters. When the quarterly rates of increase are reported, they are reported as though the changes at occurred for an entire year. That means that real GDP did not actually increase 5.6 percent during the first quarter of 2006. It grew at a rate, that if that rate of growth had continued for an entire year, real GDP would have been 5.6 percent higher. (The actual growth rate during the quarter was approximately one-fourth of 5.6 percent or slightly more than 1.4 percent.) Reporting at annual rates makes it easier to compare the change in a quarter to the change of another quarter and to the change over an entire year.

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.

There are often a number of different measures of GDP reported. Nominal GDP, or simply GDP, is total output in current prices. Real GDP is total output with prices held constant. Real GDP per capita is the real GDP per person in the economy and is the best measure of well-being of all the other measures.

One approximate means of calculating real GDP per capita is to identify the increase in nominal GDP and then subtract the percentage increase in prices and the percentage increase in population. That would leave the percentage increase in real GDP per capita.

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 policies, 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 positive sign of the strength of the current economy.

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 decreases 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.

Data Trends

During 2000 and 2001, the rate of growth of real gross domestic product slowed significantly. A recession was declared for March 2001 to November 2001. Growth increased in 2002, 2003, and 2004, reaching 4.2 percent in 2004 and then decreasing slightly in 2005 to 3.5 percent. The most recent quarter's growth rate is relatively large and is a significant increase over the last quarter of 2005. We would have to go back to the third quarter of 2003 to find a higher growth (7.2 percent) than in this quarter and back to the second quarter of 2000 (6.4 percent) before that.The Federal Reserve responded to slowing growth and the 2001 recession by reducing the target federal funds rate.

The effects of stimulative monetary policy and the resulting low interest rates helped increase consumer and investment spending during and since the recession. As the economy began to grow, the Federal Reserve reversed its policy to slow the growth to a sustainable level and has been increasing the target federal funds rate since. (See the Federal Reserve and Monetary Policy Cases.)

Long-run Trends

The rate of increase in real GDP was not only higher in the last part of the 1990s than in the first half of the 1990s, but also when compared with 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 4.2 percent per year. Growth slowed in the beginning of the 2000s, but has rebounded and averaged 3.9 over 2004 and 2005.

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. Figure 2 shows the history of growth since the 1970s. Figure 2 also shows the average annual rate of growth of 3.1 percent since 1970.

Prices

The price index for GDP increased at an annual rate of 3.1 percent during the first quarter of 2006, compared to the rate of increase of 3.5 percent during the fourth quarter of 2005. It increased at an annual rate of 2.8 percent for all of 2005. These are somewhat higher rates of increase than experienced during 2003 and 2004 (2.0 and 2.6 percent).

Clearly there has been a gradual increase in the rate of increase in prices over that period. See the latest inflation case study for a discussion of the recent increases in price levels.

Details of the First-Quarter Changes in Real GDP

Real GDP increased at an annual rate of 5.6 percent, an increase in growth over the last quarter of the year. The major contributors to the increase in the growth rate of real GDP in the first quarter when compared to the fourth quarter of last year were a significant increase in the growth of personal consumption, exports, and government. Growth in investment spending slowed, but still increased rapidly. Those increases were partially offset by rise in spending on imports.

The low growth rate of the last quarter of last year (1.7 percent) was largely due to the slowdown in production caused by the hurricanes in the southern part of the U.S. It may well be that the higher than average increase of the first quarter is due largely to a rebound from those conditions.

Recessions

On November 2001, 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 signaled the official beginning of a recession. In July 2003, the committee reported its determination of the end of the recession as of November 2001.

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 slowed but did not decline. Manufacturing and trade sales and industrial production both declined and had been doing so for some time. The two most recent recessions are shown on table 1.

The previous 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. 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 rapidly even after it came out a period of falling output and income, very similar conditions to those of the current economy.

For the full press release on recessions from the National Bureau of Economic Research see: [EEL-link id='1771' title='www.nber.org/cycles/cyclesmain.html' ]

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.

Revisions in GDP Announcements

This is the third and "final" announcement of real GDP for the first quarter of 2006. In this case, the previous rate of growth was announced as 5.3 percent for the quarter. This announcement increases that rate of growth by .3 percent.

Real GDP for each quarter is announced three times. The month following the end of the quarter is described as the advance real 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. From 1983 to 2002, the advance estimates of the rate of growth in real GDP have been revised an average of 0.5 percent in the next month's preliminary estimate. The preliminary estimates have been revised by an average of an additional 0.3 percent.

Revisions in inventory investment and the international trade data are often the causes of changes in the GDP figures. Those data for the last month of the quarter are not available when the advance estimate of GDP is announced.

This revision is primarily based on an upward change in investment spending from the "preliminary" announcement and a decrease in the amount of imports. Thus the estimate increased from a 5.3 percent rise in real GDP to a 5.6 percent rise in real GDP.

Explanations of GDP and its Components

Gross domestic product consists of goods and services produced for consumption, for investment, for government, and for export. The GDP accounts are broken down into consumption spending, investment spending, government spending, and spending on U.S. exports. To arrive at the amount actually produced (that is, GDP) our spending on imports is subtracted from those other amounts of spending. Thus,

GDP = Consumption spending + investment spending + government spending + export spending - import spending

Consumption spending consists of consumer spending on goods and services. It is often divided into spending on durable goods, non-durable goods, and services. These purchases currently account for 70 percent of GDP.

• Durable goods are items such as cars, furniture, and appliances, which are used for several years.
• Non-durable goods are items such as food, clothing, and disposable products, which are used for only a short time period.
• 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.

Investment spending 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.
• Residential investment is the building of a new homes or apartments.
• Inventory changes consist of changes in the level of stocks of goods necessary for production and finished goods ready to be sold.

Government spending 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 (19 percent) 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 5 percent of GDP. State and local spending on goods and services accounts for 12 percent of GDP, while federal spending is 7 percent of GDP.

Exports are goods and services produced in the U.S. and purchased by foreigners - currently about 10 percent of GDP.

Imports are items produced by foreigners and purchased by U.S. consumers are equal to 16 percent of GDP. Net exports (exports minus imports) are negative and are about 6 percent of the GDP.

GDP as a Measure of Well-Being

GDP fails to account for many forms of production that improve a person's well being. For example, if you make a meal at home, the labor is not included. However, if you were to go out to a restaurant and consume that same meal, the labor is included in GDP. Unpaid work at home or for a friend and volunteer work is not included and thus GDP does not reflect production of all we produce.

External effects of production, such as pollution, are not subtracted from the value of GDP. Although two countries may have similar GDP growth rates, one country may have significantly cleaner water and air, and therefore is truly better off than the other country. If as economic growth accelerates, producers begin to employ production techniques that create more pollution, the effects of the growth are overstated.

GDP includes police protection, new prisons, and national defense as goods and services. It is not always clear that if we have to devote increased resources for such purposes that we are better off as a result.

GDP includes the effects of price changes. An increase in GDP due solely to inflation does not signal an improvement in living standards. Real GDP is a better measure. Nor does GDP reflect population growth. Changes in the income distribution are not measured. It is also difficult to compare rates of growth for different countries, as countries use different means of estimating income and price levels in their economy.

There are a variety of other weaknesses and inaccuracies, but GDP accounting is the best that we have. Real GDP does provide sound signals as to the direction of change of a selected large part of what we produce each year. Government statisticians and academics are constantly working to improve its accuracy and its ability to reflect our 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 \$2.225 trillion, its GDP per capita is only \$1,716. Hong Kong has a much smaller GDP of \$178 billion. However, its GDP per capita is much higher at \$25,757. Other nations, such as France and Germany , may have quite different GDPs, but GDPs per capita that are very close. Notice also that France and Germany have GDP's not too different from China's, yet have vastly different GDP's per capita from China's.

 Country Population GDP (Billions) Per Capita GDP China (Mainland) 1,296,200,000 \$ 2,225 \$ 1,716 China (Hong Kong) 6,900,000 \$ 178 \$ 25,757 France 60,400,000 \$ 2,106 \$ 34,865 Germany 82,500,000 \$ 2,797 \$ 33,907 United States 293,700,000 \$ 12,486 \$ 42,512

Sources: Population numbers, year 2004, [EEL-link id='1135' title='www.worldbank.org' ] ,
GDP, 2001, [EEL-link id='1752' title='www.imf.org/external/index.htm' ]

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 in South America and Africa have a low GDP per capita that underestimates average 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.)

GDP, Productivity, and Unemployment

A major factor in the long-term growth in the American economy is continued improvement in productivity. Productivity increased at a revised annual rate of 3.7 percent in the first quarter of 2006 and at an annual rate of 2.7 percent in 2005. This means that businesses are able to gain more output from the same number of workers. This explains how real GDP can increase at a faster rate than the number of workers.

If real GDP grows faster (5.6%) than the increase in productivity (3.7%), more workers are needed to produce the real GDP. If unemployment is to fall, spending and output in the economy has to grow faster than the increase in productivity. In this quarter, employment did increase and unemployment did fall.

The Federal Reserve has stated in many of its recent releases that continued productivity growth is a key component in the continued growth in the American economy and important in holding down inflationary pressures. Businesses are able to expand production more rapidly than the growth in employment and thus, the most important consequence, real GDP per capita can increase. If real GDP per capita increases, average income increases and individuals in the economy are better off.

Interactive Exercise

How can we increase economic growth over time?

Economic growth is a function of the technological innovation and the amount and quality of labor and capital in the economy:

As more people are employed, the amount of capital increases, education levels increase, the quality of capital changes, or the technology increases, the productive capacity of the economy increases. Therefore, the economy can increase its output giving consumers more disposable income, promoting an increase in consumption spending, and providing resources for business to use for further investment and government to use to provide public goods and services.

Increased labor force participation increases output. Expanded, improved education creates more productive workers. Business and government spending on research and development enhance our abilities to produce and allow each worker to become more productive, increasing incomes for all. Finally, to achieve a higher level of GDP in the future, consumers need to limit consumption spending and increase savings today, permitting businesses to invest more in capital goods. If resources are invested into building an economy now, future generations will enjoy a higher level of economic growth; our businesses will produce more goods and consumers can purchase more goods. Expansion of output at rates faster than our population growth is what gives us the opportunity to enjoy higher standards of living.

Full employment real GDP

Economists define the approximate unemployment rate, at which there are not upward or downward pressures on wages and price, as full employment rate of unemployment. If unemployment falls to level below the full employment rate, there will be upward pressure on wages and prices. If unemployment rises to a very high rate, there will downward pressure on wages and prices or wages and prices will remain steady. In the middle is a level, or more likely a range, where there is not pressure on wages and prices to rise or fall.

The level of real GDP that can be produced at that rate of unemployment is described at the full employment level of real GDP. Sometimes it is described as the potential level of real GDP. It is the highest level that an economy can produce at any given time without causing significant inflation.

Discussion question

Given the data in this case study, what would you recommend for monetary policy?

Interactive Exercise