In March of 2001, a recession began. The current case examines the changes in real GDP in the most recent quarter and how those changes reflect the current recessionary conditions. The definition of a recession is a "significant decline in total output, income, employment, and trade, usually lasting from six months to a year, and marked by widespread contractions in many sectors of the economy."
Consumers, Economic Growth, Exports, Government Expenditures, Gross Domestic Product (GDP), Imports, Investing, Nominal Gross Domestic Product (GDP), Per Capita Gross Domestic Product (GDP), Real Gross Domestic Product (GDP)
Current Key Economic Indicatorsas of November 30, -0001
Real Gross Domestic Product (GDP) during the third quarter (July through September) of 2001 decreased at an annual rate of 1.1 percent. This is the "preliminary" estimate for the third quarter. The estimate is based on incomplete data and will be revised in the final announcement in December. During the first and second quarters of 2001, real GDP increased at an annual rate of 1.3 percent and 0.3 percent respectively.
For the year 2000, real GDP increased at annual rates of 2.3, 5.7, 1.3, and 1.9 percent in each of the four quarters. The slowing rate of growth throughout 2000 has continued through 2001. The growth rate in real GDP over the last 12 months has been 0.8 percent. That compares with a more than 4 percent annual growth rate over the last several years.
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.
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 rate of change in real GDP and the accompanying related data in the U.S. economy.
- Descriptions of major issues surrounding the data announcements.
- Brief analysis of historical perspectives.
- Questions and activities to use to reinforce and develop understanding of relevant concepts.
- A list of publications and resources that may benefit classroom teachers and students interested in exploring inflation.
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.
The growth in real GDP over the past few years 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, reinforcing concerns that our economy is in a recession. The last recession began in July of 1990 and continued through March of 1991.
The Federal Reserve has responded to slowing growth and the potential of recession by reducing the target federal funds rate by 450 basis points (4.5%) from January 2001 to November 2001. (See the November 11 Federal Reserve System and Monetary Policy Case and the upcoming December 11 Federal Reserve case.)
The price index for GDP increased at an annual rate of 2.2 percent in the third quarter of 2001, compared to 2.3 percent for 2000.
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 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 increase of consumption spending, investment spending, and exports. Productivity increases, decreases in unemployment, expansions 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 Third-Quarter Changes in Real GDP
Real GDP in the third quarter fell from its level in the second quarter of 2001. Personal consumption expenditures and government spending increased during the third quarter, but both increased at significantly slower rates than in recent quarters. The slower growth in government spending was almost entirely due to the elimination of any increases in state and local government spending.
Even these increases were offset by declines in nonresidential fixed investment and a decrease in private inventory 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, but at a slower rate of increase. Real consumption spending increased at an annual rate of 1.1 percent, as compared to 2.9 percent for the previous three quarters. There are indications that the growth in consumer spending slowed each month during the quarter.
Real investment decreased at an annual rate of 10.7 percent during the third quarter, compared to a decrease of 12.1 in the second quarter. The largest part of the decrease in investment spending was due to a reduction in non-residential fixed investment, such as structures, equipment, and software. Businesses continued to reduce their inventories.
Exports decreased by 17.7 percent (compared to a decrease of 11.9 percent in the second quarter) and imports decreased by 12.9 percent (compared to a decrease of 8.4 percent in the second 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. In addition, there is much discussion and debate about the effects of a fourth-quarter increase in government spending. The short-run effects of both the monetary policy and the increase in government spending should be some stimulus to spending.
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 recent 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.
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.
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 second quarter to a level of $10,229.7 billion. The rate of change in nominal GDP (1.1%) equals the change in real GDP (-1.1%) plus the change in prices of goods included in nominal GDP (2.2%). The latter is represented by the GDP deflator , sometimes described as the GDP price index.
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 69 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. 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 (14%).
- 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 (17.5%).
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 (16%). Thus, net exports (exports minus imports) are negative, about -4% 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.
|Country||Population||GDP (billions)||Per Capita GDP|
|China (Hong Kong)||
|1999 Real GDP in billions of current US dollars (International Monetary Fund)|
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.
|Are estimates of GDP accurate measures of our well-being?|
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
[Note: You may use this reproducible to discuss these questions in class.]
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
[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 is part of investment spending. Wages are not included.]
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, and the lenders. An alternative way of calculating GDP is to add all of the incomes earned by all participants in the economy.]
Charts from this lesson