Explore the connection between the economic indicators and real-world issues. These lessons typically can be done in one class period.
Current Key Economic Indicatorsas of November 30, -0001
Real Gross Domestic Product (GDP) during the first quarter of 2001 increased at an annual rate of 1.3 percent. This is the "preliminary" estimate for first quarter. (This "preliminary" estimate is actually a revision of the "advance" released one month ago. This "preliminary" estimate is still based on incomplete data and will be revised once again in a "final" estimate to be released next month.) During 2000, real GDP increased at annual rates of 4.8, 5.6, 2.2 and 1.0 percent in each of the four quarters.
From 1999 to 2000, real GDP increased by 5.0 percent, compared to an annual increase of 4.2 percent from 1998 to 1999.
The growth in real GDP over the past few years has been relatively high when compared to much of the 1990s. However, during the last two quarters of 2000 and into the first quarter of 2001, the rate of growth of real gross domestic product slowed tremendously. The combined growth rates in real GDP during the fourth quarter in 2000 and the first quarter of 2001 was the lowest since the second quarter of 1995 and is perhaps one more signal that the Federal Reserve's efforts during 1999 and 2000 to slow the rate of increase in spending in the economy have had significant effects. From June 1999 to last summer, the Federal Reserve used its monetary policy to increase interest rates in order to prevent inflationary pressures.
During the first quarter of 2001, real GDP increased at only a slightly faster rate than during the fourth quarter of 2000. These low increases in real GDP indicate that spending and production are still increasing, but many economists are concerned that our economy is headed into a recession. The last recession began in July of 1990 and continued through March of 1991. (See the discussion of the recession below.)
This ten-year economic expansion is the longest expansion, without a recession, on record. The Federal Reserve has responded to the concerns about a possible slowing in growth of output and a potential recession with five reductions in the target federal funds rate, the first in January 2001 and the most recent in May 2001, for a total decrease of 2.5% in the federal funds rate. (See the May Federal Reserve System and Monetary Policy case.)
The slowing growth in spending relative to a year ago appears to be caused by consumers reducing the growth in their spending and businesses reducing the amount of investment spending. Both events result in businesses further cutting investment in equipment and inventories, as not as much of either are needed.
Businesses may reduce spending further. Consumers might become less confident about the future and reduce spending. In either case, total spending can actually fall. Last month, news articles and television coverage discussed the slowing growth in spending (from 5.6 percent to 2.2 percent to 1.0 percent in the previous three quarters) and the likelihood of zero growth in the first quarter of 2001. Predictions of an upcoming recession were common. Proposals to use tax policy to encourage consumers to increase spending and businesses to increase investment were supported by Republicans and Democrats alike. The "advance" estimate last month showed an increase of 2 percent in real GDP. News reports used those figures to be an indication of a recovering economy. This revision to the lower 1.3 percent should remind us to be cautious in using any one set of data and particularly in using advance and preliminary data.
The price index for the domestic purchases portion of GDP increased at an annual rate of 2.8 percent in the first quarter of 2001, compared to 1.9 percent in the fourth quarter of 2000. For all of 2000, the price index increased 2.4 percent, compared to a 1.6 percent increase during all of 1999.
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 3.9, with the last three years being over 4.3 percent per year. A five percent increase from 1999 to 2000 is the highest level of yearly increase since 1984.
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, decreases in unemployment, expansion in the labor force, 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.
Details of the First-Quarter Changes in Real GDP
The rate of increase in real GDP in the first quarter is slightly higher than the rate of increase in the fourth quarter of 2000, but still remains low compared to quarters earlier in 2000. Personal consumption and government spending increased at somewhat faster rates during the quarter. However, these increases were offset by large decreases in inventory investment and continuing small decreases in business purchases of equipment and software. Imports, which are subtracted from real GDP decreased, and exports, which are added to real GDP decreased as well, but by a smaller amount. Thus the effect of the changes in net exports was to increase spending in the economy.
Real investment decreased by 13.3 percent, compared to a decrease of 4.1 percent in the previous quarter. The largest part of the decrease in investment spending was due to a reduction in business inventories. Businesses continued to adjust inventories downward in order to reduce undesired inventories that have accumulated. Businesses also reduced their purchases of equipment and software.
Exports decreased by 2.7 percent (compared to a decrease of 6.4 percent in the fourth quarter) and imports decreased by 9.1 percent (compared to an decrease of 1.2 percent in the fourth quarter).
Real government spending increased at an annual rate of 4.7 percent.
Changes in Nominal Gross Domestic Product
Nominal GDP, that is GDP measured in current prices, increased at annual rate of 4.6 percent, in the first quarter to a level of $10,229.4 billion. The difference between the rates of increase in the nominal gross domestic product (4.6%) and the real gross domestic product (1.3%) is the rate of change in prices of goods and services included in gross domestic product. That is the GDP deflate (or price index) and it increased at an annual rate of 2.8 percent. (The rates of increase may not always add exactly due to rounding errors and the preliminary nature of the estimates.)
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.
The Last Recession
Real gross domestic product is not always equal to the value of production if all resources (labor and capital) are fully employed. Fluctuations around the economy's capacity to produce are often described as business cycles.
When the economy is not fully utilizing its labor and capital, real GDP is less than its potential. When the economy is shrinking away from its potential, we describe the economy as being in a recession. This may occur for a variety of reasons. One possible scenario is when consumption spending falls (or grows more slowly than anticipated) and inventories accumulate. As a result, businesses will cut back on production in an effort to reduce inventories. Unemployment may rise as workers are laid off and this reduces incomes, which in turn reduces consumption spending further. Investment spending on plant and equipment may also decline, as businesses become pessimistic about future sales and needed production.
The definition of a recession appearing most often in the daily news is a period of two or more successive quarters of decreasing real GDP. The National Bureau of Economic Research makes the decisions determining the official beginnings and ends of recessions. They use a more comprehensive definition of a recession. A recession to the NBER is a period of declining real GDP, employment, and income lasting more than six months and accompanied by declines in many parts of the economy.
The most recent recession lasted from July 1990 through March 1991. At the beginning of 1990, the US appeared to be producing near the full-employment level of production with an unemployment rate of 5% and inflation at 4%. However, the Gulf War in Iraq resulted in a series of demand and supply shocks. The price of oil more than doubled, causing a decrease in aggregate supply. Investment spending fell due to the economic and political uncertainty, which caused a multiplied effect on consumption spending, resulting in a decrease in aggregate demand. As production declined, unemployment increased. Inflation increased as a result of the supply shock. These trends are displayed in the figure below, along with the Federal Reserve's monetary policy responses. In response to the slowing economic growth, the Federal Reserve Board lowered the target federal funds rate. By the end of 1991, the economy had recovered from the eight month recession.
The table shows the decrease in the growth rate of real GDP and the actual decreases in real GDP in third and fourth quarters of 1990 and the first quarter of 1991. Changes in productivity match the changes in real GDP. Unemployment was rising throughout. Inflation increased as the price of oil increased and then fell as the recession started. The target federal funds rate was lowered throughout the period in an attempt to bring the economy out of the recession.
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 only includes goods and services produced within the U.S.
- It measures current production because it only includes 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 only count 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 gain 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.
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 68 percent of GDP in the third quarter. These purchases accounted for 68 percent of GDP in the first quarter.
- 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. (38%) Services are the fastest growing part or consumption spending.
Investment spending (I) consists of nonresidential fixed investment, residential investment, and inventory changes. Investment spending accounts for 19 percent of GDP, but varies significantly from year to year.
- Nonresidential 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 (15%).
- 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. (Less than 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. (17%)
Net Exports (NX) is equal to exports minus imports. Exports are items produced in the US and purchased by foreigners (12%). Imports are items produced by foreigners and purchased by US consumers. (16%). Currently, the US imports more than it exports so that net exports are negative, about -4% of the GDP. (For more information on the balance of trade, see the Trade Report case study.)
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 a year are published. An example of previous revisions, the three announcements for the annual rates of change in the second quarter are shown below.
|Annual rates of change in Real GDP||Advance||Preliminary||Final|
|Second Quarter, 2000||5.2%||5.3%||5.6%|
|Third Quarter, 2000||2.7%||2.4%||2.2%|
|Fourth Quarter, 2000||1.4%||1.1%||1.0%|
|First Quarter, 2001||2.0%||1.3%||-|
Revisions in inventory investment and the international trade data are often the cause of changes in the GDP figures. Because changes in inventories and international trade date make up significant portions of the current report, one should be particularly cautious in using the "advance" figures.
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 GDP's, but real GDPs per capita that are very close.
|Country||Population||GDP (billions)||Per Capita GDP|
|China (Hong Kong)||
|1999 Real GDP in billions of current US dollars (International Monetary Fund)|
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.
A stereo produced and sold in the US by a Japanese company
[Consumption - A stereo produced and purchased in the US is counted as a consumption good and not an import, regardless of the ownership of the company.]
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.]
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.]
A space shuttle launch
The purchase of a plane ticket to London on British Airways
[Imports and consumption - This is an import and a consumption good because it is the consumption of a good produced outside the US by a consumer in the US.]
The purchase of a US Treasury Bond by an individual
[Not included - The purchase of a US Treasury Bond is a transfer of money from the consumer to the Treasury and does represent the production of goods and services.]
A new factory
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.]
A bottle of French wine, sold in the US
[Imports and consumption - This is both an import and a consumption good, because it was produced outside the US and purchased by a consumer in the US for personal consumption.]
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.]
A home cooked meal
A dinner at a restaurant
A computer produced in the US and sold in Canada
A new interstate
OTHER QUESTIONS FOR STUDENTS
Given the following data (in billions of current dollars), calculate the current level of gross domestic product.
[Gross domestic product will equal consumption spending ($7,000), plus investment spending ($1,500 + 200), plus government spending on goods and services ($550 + 1,300), plus exports ($1,100), minus imports ($1,500). GDP = $10,150 billion, or $10.150 trillion.
Social security payments are not included, as they are transferring income from one set of individuals, taxpayers, to another, social security recipients. Goods and services are not produced. For basically the same reasons, taxes are not included.
Construction of new homes are part of investment spending. Wages are not included. ]
|Social security payments||500|
|Income tax receipts||1,000|
|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|
If gross domestic product increases by 10 percent over a year, are we better off? Why or why not?
[Perhaps we are better off. Part of the answer depends upon what is happening to prices and what is happening to population. If prices and population together are rising by more than 10 percent per year, than we, on average, are worse off. We have fewer goods and services per person.]
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?
[As more is produced, more labor is hired. Increasing demand for labor will eventually cause wages to begin to rise. Although workers benefit, the increased wages will eventually put upward pressure on the prices businesses have to charge to cover their new higher costs. If the Federal Reserve is concerned with rising inflationary pressures, they will be concerned with the rapid rates of increase in GDP.]
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?
[Consumption spending will remain the same; however, imports will increase. Real GDP in the US will decrease. In the second instance, consumption spending increased, but imports increased by an equal amount. Real GDP does not change. The components do change.]
Why are wages and profits not included in gross domestic product?
[Gross domestic product includes all of the production of goods and services in a year. Production of consumption, investment, government, and net export goods is included. Therefore, wages are not added to the total amounts of production when calculating GDP. But, production also generates income. Every dollar that is spent on goods and services eventually becomes income to someone - the workers, the owners, the lenders. An alternative way of calculating GDP is to add all of the incomes earned by all participants in the economy.]