Announcement

Real Gross Domestic Product (GDP) during the fourth quarter (October through December) of 2001 increased at an annual rate of 1.4 percent. This is the "preliminary" estimate for the fourth quarter and is a revision of the announcement of a .2 percent increase that was made one month ago. It is still based on incomplete data and will be revised in the "final" estimates one month from now. During the first three quarters of 2001, real GDP changed at annual rates of +1.3 percent, +0.3 percent and -1.3 percent respectively.

The growth rate in real GDP for all of 2001 has been 1.2 percent. That compares with a 4.1 percent annual growth rate in both 1999 and in 2000. The slower rate of growth that we are experiencing now is a trend that began in late in 2000 and continued throughout all of 2001.

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. 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. 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.

Most important, changes in real GDP per capita provide our best measures of changes in our material standards of living.

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.

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 tremendously. During the third quarter of 2001, real GDP was actually negative for the first time since 1993 - one indication that our economy is in a recession (beginning in March 2001). The previous recession began in July of 1990 and continued through March of 1991.

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 the January 30 Federal Reserve System and Monetary Policy Case). The effects of stimulative monetary policy and the resulting low interest rates helped increase consumer spending during the fourth quarter, partially responsible for the increase in real GDP in the fourth quarter.

The price index for GDP declined 0.2 percent during the fourth quarter. It increased at an annual rate of 2.2 percent for 2001, compared to 2.3 percent for 2000.

Figure 1: Quarterly Changes in Real GDP at Annual Rates (1990-2001)

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 being at or over 4.1 percent per year.

Figure 2: Annual Percentage Changes in Real GDP (1970-2000)

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. During this same time period, consumers have reduced their savings. Personal savings as a percentage of disposable income fell to one-half of one percent during the fourth quarter.

Details of the Third-Quarter Changes in Real GDP

Real GDP increased by 1.4 percent in the fourth quarter compared to a decline of 1.3 percent in the third quarter of 2001. Personal consumption expenditures and government spending increased during the fourth quarter to their highest rates of increase since 1998. The growth in government spending was almost entirely due to increased federal defense spending for the war of terrorism, as well as increased state government spending and investment.

Even these increases were largely offset by decreases in nonresidential fixed investment, private inventory investment and residential investment. Imports, which are subtracted from real GDP, decreased, but exports, which are added to real GDP, decreased by a greater amount. Thus the effect of the changes in net exports was to decrease spending in the economy.

Consumers continued to increase spending during the fourth quarter of 2001. Real consumption spending in the fourth quarter increased at an annual rate of 6.0 percent, as compared to 2.2 percent for the previous three quarters. The increase in consumption spending was primarily due to a 39 percent increase in spending on durable goods such as automobiles and appliances. For the entire year, consumption spending increased at a rate of 3.1 percent, compared to 4.8 percent in 2000 and 5.0 percent in 1999.

Real investment decreased at an annual rate of 23.3 percent during the fourth quarter, compared to a decrease of 10.5 in the third quarter. For all of 2001, investment spending decreased 8.0 percent. The largest part of the decrease in investment spending was due to a reduction in non-residential fixed investment, with investment in non-residential structures falling 33 percent. Residential investment also decreased, following an increase in the third quarter. Businesses continued to reduce their inventories.

Exports decreased by 12.2 percent (compared to a decrease of 18.8 percent in the third quarter) and imports decreased by 6.9 percent (compared to a decrease of 13 percent in the third quarter). Thus net exports fell slightly during the quarter.

Monetary policy has been used to encourage consumers to increase spending and businesses to increase investment. The short-run effects of both the monetary policy and the increase in government spending should be some stimulus to spending. In the fourth quarter, the effects of low interest rates (and zero-percent financing by many car dealerships) are seen in the increased purchases of durable goods such as automobiles and appliances.

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 to 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.

While the common media definition of a recession is two consecutive quarters of decline in real GDP, this recession is beginning before quarterly real GDP actually has declined.

Current news reports do discuss possibilities of the terrorist attacks actually increasing the severity and length of the recession. If that happens, it would likely be due to falling consumption spending due to declining consumer confidence, declines in industries most directly affected by the terrorism (travel and tourism, being prime examples), and further cutbacks in business investment spending. However, as seen during this quarter, consumers are increasing their spending and there is significant speculation that we are currently coming out of the recession.

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

Changes in Nominal Gross Domestic Product

Nominal GDP - that is, GDP measured in current prices - increased at annual rate of 1.1 percent in the fourth quarter to a level of $10,253.2 billion. The rate of change in nominal GDP (1.1%) equals the change in real GDP (1.4%) plus the change in prices of goods included in nominal GDP (-0.2%). The latter is represented by the GDP deflator, sometimes described as the GDP price index. (The numbers do not add up exactly due to errors in rounding).

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.

How can we increase economic growth in the future?

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 first quarter.

  • Durable goods are items such as cars, furniture, and appliances, which are used for several years (11%).
  • 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 (13%).
  • 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 does not include transfer payments such as Social Security, unemployment compensation, and welfare payments, which do not represent production of goods and services (18%).

Net Exports (NX) is equal to exports minus imports. Exports are items produced in the U.S. and purchased by foreigners (11%). Imports are items produced by foreigners and purchased by U.S. consumers (15%). Thus, net exports (exports minus imports) are negative, about -4.5% 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 real GDP of $991 billion, its real GDP per capita is only $791.30. Hong Kong has a much smaller real GDP of $159 billion. However, its real GDP per capita is much higher at $23,639.58. Other nations, such as France and Germany, may have quite different GDPs, but real GDPs per capita that are very close.

1999 Real GDP in billions of current US dollars (International Monetary Fund)
Country Population GDP (billions) Per Capita GDP

China (Mainland)

1,249,671,000

$991.07

$791.30

China (Hong Kong)

6,877,000

$158.61

$23,639.58

France

60,794,000

$1,435.48

$24,593.62

Germany

82,027,000

$2,114.73

$25,782.08

United States

272,878,000

$9,256.15

$33,933.58

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. Over the past five quarters, the advance estimates have been revised by +0.1 to -0.7 percent with an average decrease of 0.3 in the rate of growth of GDP and the preliminary estimates have been revised by +0.3 to -0.5 percent with an average decrease of 0.1 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 "preliminary" figures.

The advance estimate was increased by 1.2 percent this month (from .2 to 1.4). The large upward revision to the rate of growth in real GDP was primarily due to a relatively small downward revision for imports of goods and a rather large upward revision in consumption expenditures and in government spending.

Are estimates of GDP accurate measures of our well-being?

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 Students

  1. Given the following data (in billions of current dollars), calculate the current level of gross domestic product.
    Consumption spending $7,000
    Social security payments 500
    Income tax receipts 1,000
    Exports 1,100
    Business purchases of new factories and equipment and changes in inventories 1,500
    Federal government spending on goods and services 550
    Construction of new homes 200
    State and local spending on goods and services 1,300
    Imports 1,500
    Wages 6,000

    If gross domestic product increases by 10 percent over a year, are we better off? Why or why not?

  2. Increases in real GDP represent more production of goods and services. Why would the Federal Reserve ever undertake a policy to slow down the rate of growth in production?
  3. If consumers begin to purchase automobiles manufactured abroad instead of those manufactured in the US, what will happen to real GDP? Will the answer be different if consumers are simply increasing their spending and those purchases are of automobiles manufactured abroad?
  4. Why are wages and profits not included in gross domestic product?