Announcement

Real Gross Domestic Product (GDP) during the third quarter (July, August, and September) of 2004 increased at an annual rate of 3.8 percent. This is the first estimate of the rate of change in the third quarter.

This compares to annual rates of 3.8 and 3.3 percent in each of the first two quarters of 2005. For the entire 2004 year, real GDP increased at a rate of 4.2 percent. Annual growth rates in 2001, 2002, and 2003 were .8, 1.6, and 2.7 percent.

Please do the following multiple choice activity:

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 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. (See below for a discussion of the 2001 recession.)

Data Trends

The growth in real GDP at the end of the 1990s was relatively high when compared with the early part of the 1990s. However, during 2000 and 2001, the rate of growth of real gross domestic product slowed significantly. A recession began in March 2001 and lasted to November 2001.

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 again by another .5 percent in November 2002 and another .25 percent in June of 2003). (See the 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. As the economy began to grow, the Federal Reserve reversed its policy to slow the growth to a sustainable level. It started increasing the target federal funds rate in June of 2004 and have continued increasing the target at every meeting since.

Figure 1: Quarterly Changes in Real GDP at Annual Rates (1990-2005)

Long-run Trends

The rate of increase in real GDP has been 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 4.1 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.

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

Figure 2: Annual Percentage Changes in Real GDP (1970-2004)

Prices

The price index for GDP increased at a rate of 3.1 percent during the third quarter of 2005, compared to an increase of 2.6 percent during the second quarter of 2005. It increased at an annual rate of 2.6 percent for all of 2004. One of the reasons for the changes in policies of the Federal Reserve is to slow the rate of growth in spending and to lower the possibility of increasing inflation.

Details of the First-Quarter Changes in Real GDP

Real GDP increased at an annual rate of 3.8 percent, a slight increase in growth from the second quarter. The major contributors to the increase in real GDP in the third quarter were increases in personal consumption, investment in housing and equipment and software, and an increase in national defense spending. Those increases were partially offset by a decrease in inventory investment.

GDP, Productivity, and Unemployment

A major factor in the long-term growth in the American economy is continued improvement in productivity. (See the most recent Productivity case study). Productivity increased at an annual rate of 1.8 percent in the second quarter of 2005 and 2.2 percent for the last 12 months. Businesses are able to gain more output from the same number of workers. This explains how real GDP can increase at the same time employment is increasing but at a slower rate. If real GDP grows at 3.8 percent and productivity is increasing at about 1.8 percent (not yet announced for this quarter), the growth in employment would be approximately 2 percent.

The Federal Reserve has stated in recent releases that continued productivity growth is a key component in the continued growth in the American economy. Businesses are able to expand production more rapidly than the growth in employment and thus real GDP per capita can increase.

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 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 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 very 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 from the National Bureau of Economic Research see: [EEL-link id='1684' title='www.nber.org/cycles/november2001/' ]

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 16 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 (6%).
  • Inventory changes consist of changes in the level of stocks of goods necessary for production and finished goods ready to be sold (less than 1%).

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 15 percent of GDP. Net exports (exports minus imports) are negative and are about 5 percent of the GDP.

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 $1.2 trillion, its GDP per capita is only $911. Hong Kong has a much smaller GDP of $162 billion. However, its GDP per capita is much higher at $23,880. 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

Sources: Population numbers, year 2000, www.worldbank.org; GDP, 2001, www.imf.org
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.]

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 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. Since 1978, 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.

Interactive questions

Use this data (in billions of dollars) to answer the questions in the following interactive activity.

Social security payments

$1,000

Income tax receipts

$1,500

Exports

$2,100

Wages

$9,000

Consumption spending

$8,000

Federal government spending on goods and services

$750

Construction of new homes

$400

State and local spending on goods and services

$1,250

Changes in inventories

-$500

Imports

$2,500

Business purchases of new factories and equipment

$2,000

 

 

 

  Please do the following multiple choice activity: