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Focus on Economic Data: Gross Domestic Product - November 25, 2003

Key Economic Concepts:

• Exchange Rate
• Exports
• Imports

Description:

The U.S. international trade deficit in goods and services slightly increased to $40.3 billion in July from a revised $40 billion in June. Exports increased by $1.7 billion and imports increased by a slightly larger number, $2.0 billion).

Announcement

Real Gross Domestic Product (GDP) during the third quarter (July through September) of 2003 increased at an annual rate of 8.2 percent.

Notes to Teachers

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

You may wish to use the following larger versions of the graphs and tables from this lesson for overhead projection or handouts in class:

• PDF (14 KB)
• Power Point (38 KB)

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.

Announcement

Real Gross Domestic Product (GDP) during the third quarter (July through September) of 2003 increased at an annual rate of 8.2 percent. This is the second release of the number and was revised upward from the initial announcement of 7.2% released one month ago. This compares to rates of 1.4 and 3.3 percent in the first and second quarters of 2003. During 2002, real GDP changed at annual rates of 5.0 percent, 1.3 percent, 4.0 percent and 1.4 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.

Meaning of the Announcement

The U.S. economy was in a recession during most of 2001 and has experienced only modest growth in real GDP since. In fact, employment has fallen and unemployment has increased for much of the time since the recession ended in November of 2001. This announcement, which is an even more rapid rate of increase than previously announced, along with improving employment reports is good news. However, we should be cautious with the results of any single quarter. (Real GDP did increase as much as 5.0 percent in the first quarter of 2002, only to fall to significantly lower rates of increase since.)

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.

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, the rate of growth of real gross domestic product slowed significantly and during the first three quarters of 2001, the rate of growth of real gross domestic product was actually negative as the U.S. economy entered a recession in March of 2001 lasting through November of 2001. The changes in real GDP were actually negative for the first time since 1993.

The Federal Reserve 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 and then two more times since. The most recent was in June of 2003. (See Federal Reserve and Monetary Policy Cases.) The effects of stimulative monetary policy and the resulting low interest rates helped increase consumer spending during and since the recession.

The price index for GDP increased at an annual rate of 1.7 percent during the third quarter of 2003, compared to an increase of 1.0 percent during the second quarter of 2003. It increased at an annual rate of 1.1 percent for 2002, compared to 2.4 percent for 2001.

The rate of increase in real GDP has been not only higher in the last several years than in the first part 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 4.1 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. Increases in productivity, that is, output per hour worked, are the key to increases in real GDP per capita and therefore to increases in material standards of living.

Details of the Third-Quarter Changes in Real GDP

Real GDP increased at an annual rate of 8.2 percent in the third quarter of 2003 compared to a rise of 3.3 percent in the second quarter of 2003. The major contributors to the increase in real GDP were the increase in consumption spending, business investment, and investment in housing. There was also a small increase in exports and a slower rate of growth in imports, both of which contributed to a more rapid rise in real GDP. Federal government spending on defense actually fell after the second quarter extremely rapid rise of 45 percent.

Gross private domestic investment increased at an annual rate of 18.2 percent during the third quarter of 2003, compared to an increase of 2.0 percent in the second quarter of 2003. For all of 2002, investment spending increased by only 1 percent.

Third quarter exports increased by 11 percent (compared to a decrease of 1 percent in the second quarter) and imports increased by 1.5 percent (compared to an increase of 8.8 percent in the second quarter). Net exports rose significantly during the quarter.

GDP, Productivity, and Unemployment

A major factor in the continued growth in the American economy, as seen in the strong increase of 8.2% real GDP growth in the third quarter, is the continued improvement in productivity.

Productivity, defined as the amount of output per hour of work, increased at an annual rate of 8.1% in the third quarter and 7.0% growth in the second quarter. Businesses are able to gain more output from the same number of workers, boosting economic results. This explains how the economy continues to grow strongly even as the unemployment rate stays high and employment grows only slowly.

The Federal Reserve has stated in its recent releases that continued productivity growth is a key component in the continued growth in the American economy. Businesses are able to keep costs low by reducing the need to hire new employees to create growth. The biggest cause of this productivity growth has been investment in information technology and software. This growth has allowed the Fed to cut rates more than it would otherwise, as inflationary pressures are reduced. Alan Greenspan has repeatedly cited productivity growth and was one of the first to view the 1990's boom in technology spending as a period of sustainable growth above historical levels. Eventually, continued productivity and economic growth will spur new investment and hiring.

Recessions

On November 26, 2001, the National Bureau of Economic Research (NBER) 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. More recently the NBER announced that the recession actually ended in November of 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 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 (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 ends of that recession and the most recent one were so difficult to determine was that 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.html ^[1]

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 the third quarter.

• Durable goods are items such as cars, furniture, and appliances, which are used for several years (9%).
• Non-durable goods are items such as food, clothing, and disposable products, which are used for only a short time period (21%).
• 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 (41%).

Investment spending (I) consists of non-residential fixed investment, residential investment, and inventory changes. Investment spending accounts for 15 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 (10%).
• Residential investment is the building of a new homes or apartments (5%).
• Inventory changes consist of changes in the level of stocks of goods necessary for production and finished goods ready to be sold (0%).

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 (19%) 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.

Net Exports (NX) is equal to exports minus imports. Exports are items produced in the U.S. and purchased by foreigners (10%). Imports are items produced by foreigners and purchased by U.S. consumers (14%). Thus, net exports (exports minus imports) are negative, about - 4% of the GDP.

A Trade Deficit

In the latest announcement of U.S. international trade conditions, the Department of Commerce said that total September exports of $86.2 billion and imports of $127.4 billion resulted in a goods and services deficit of $41.3 billion, $1.8 billion more than the $39.5 billion than the revised August amount.

If the trade deficit continues at the same pace of a year, the deficit in trade would be almost $500 billion dollars or 4.5 percent of GDP. Such a deficit, particularly at a time of relatively high unemployment, raises concerns and often results in political pressure to use tariffs and quotas to reduce imports. The goal of such a policy is to make imports more expensive and cause consumers and businesses to switch to domestically produced goods. The intended final result is to increase employment and decrease unemployment in the U.S.

Such a policy is however counterproductive.

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 U.S. by a Japanese company
   [Consumption – A stereo produced and purchased in the U.S. is counted as a consumption good and not an import, regardless of the ownership of the company.]
   
2. College tuition
   [Consumption]
3. Social Security payments
   [Not included – This is a type of transfer payment and is not included in GDP, because it does not represent the production of goods and services.]
4. Microsoft stock purchased from Microsoft
   [Not included – The purchase of a stock is a transfer of money and does not represent the production of goods and services.]
5. A space shuttle launch
   [Government]
6. The purchase of a plane ticket to London on British Airways
   [Imports and consumption – This is an import and part of consumption, because it is the consumption of a good produced outside the U.S by a consumer in the U.S.]
7. The purchase of a U.S. Treasury Bond by an individual
   [Not included – The purchase of a U.S. Treasury Bond is a transfer of money from the consumer to the Treasury and does represent the production of goods and services.]
8. A new factory
   [Investment]
9. The sale of a previously occupied house
   [Not included – Only current construction is counted in GDP. The house was accounted for in GDP when it was originally built. When resold later, it does not represent the production of goods and services.]
10. A bottle of French wine, sold in the U.S.
    [Imports and consumption – This is both an import and a consumption good, because it was produced outside the U.S. and purchased by a consumer in the U.S. for personal consumption.]
11. A television produced, but not sold.
    [Investment – A good that is produced but not sold is counted as an increase in business inventories, a category of investment. They are counted in GDP because they represent the current production of goods; they are a business investment to be sold in the future.]
12. A home cooked meal
    [Not included]
13. A dinner at a restaurant
    [Consumption]
14. A computer produced in the U.S. and sold in Canada
    [Export]
15. A new interstate
    [Government]

Links Used:

1. ^{^} "Business Cycle Expansions and Contractions" - (cycles-www.nber.org) A full press release from the National Bureau of Economic Research is published on this site.

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