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Announcement

Real Gross Domestic Product (GDP) during the third quarter (July through September) of 2002 increased at an annual rate of 3.1 percent. This is the advance release and will be updated in the November 26th release of the GDP data. This compares to rates of 5.0 percent in the first quarter and 1.3% in the second quarter of this year.. During 2001, real GDP increased by .3 percent - a year in which real GDP fell during the first three quarters. Annual growth rates in 1999 and 2000 were 4.1 percent and 3.8 percent.

Attention 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.

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 both as a sign that the economy continues to recover from a recession in 2001 and that the increase is somewhat less than many observers expected.

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 2001 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. 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. (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 a rate of 1.4 percent during the third quarter of 2002, compared to an increase of 1.5 percent during the second quarter of 2002 (excluding volatile food and energy prices). It increased at an annual rate of 2.4 percent for 2001, compared to 2.1 percent for 2000.

Figure 1: Quarterly Changes in Real GDP at Annual Rates (1990-2002)

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 to 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.

Figure 2: Annual Percentage Changes in Real GDP (1970-2001)

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.

Details of the Third-Quarter Changes in Real GDP

Real GDP increased at an annual rate of 3.1 percent in the third quarter of 2002 compared to a rise of 1.3 percent in the second quarter of 2002. The major contributor to the increase in real GDP was the increase in consumption spending. A larger part of that increase was the increase in spending on durable goods - mostly on automobiles.

Gross private domestic investment decreased slightly at an annual rate of -0.3 percent during the third quarter of 2002, compared to an increase of 7.9 percent in the second quarter of 2002. The most important causes of the decrease in the second quarter was a decrease in construction of business structures.. For all of 2001, investment spending decreased 10.7 percent.

Government spending increased slightly during the quarter with most of the increase due to increased spending on national defense.

Exports increased by 2.1 percent (compared to an increase of 14.3 percent in the second quarter) and imports increased by 2.5 percent (compared to an increase of 22.2 percent in the second quarter). Net exports fell slightly during the quarter.

Recessions

On November 26, 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 signals the official beginning of 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.

As seen during this quarter, consumers are increasing their spending and businesses are increasing inventories. Government spending continues to increase and investment spending is increasing, all of which contribute to speculation that we are currently coming out of the recession. While it is not official, a consensus may be that the recession ended in December or January.

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

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 2001

  • 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 (18%) 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 4 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 (12%). 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.)

How can we increase economic growth in the future?

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 $991 billion, its GDP per capita is only $791.30. Hong Kong has a much smaller GDP of $159 billion. However, its GDP per capita is much higher at $23,639.58. Other nations, such as France and Germany, may have quite different GDPs, but GDPs per capita that are very close.

2001 GDP in billions of current US dollars
(International Monetary Fund, World Bank)
Country Population GDP (billions) Per Capita GDP

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.)

Are extimates of GDP accurate measures of our well being?

The U.S. as a Wealthy Country

Country   Percentage of Global GDP   Population   Percentage of World Population

Worldwide Gross Domestic Product
Estimates of 2001 GDP in billions of current US dollars

United States   32.9%   281,550,000   4.65%
Japan   13.4%   126,870,000   2.09%
Germany   6.0%   82,150,000   1.36%
United Kingdom   4.6%   59,739,000   0.99%
France   4.2%   58,892,000   0.97%
China   3.7%   1,262,460,000   20.84%
Italy   3.5%   57,690,000   0.95%
Canada   2.3%   30,750,000   0.51%
Mexico   2.0%   97,966,000   1.62%
Spain   1.9%   39,465,000   0.65%

An alternative way of comparing the size of world economies is to calculate the percentage of the world GDP (approximately $32 trillion) produced in each country and compare that to the percentage of the world's population living in each country. As seen in the table above, the top ten countries in terms of gross domestic product comprise 75 percent of the global GDP with only 35 percent of the world's population. The U.S. alone produces a third of the goods bought and sold around the world with only 4.7 percent of the world's population. There are significant differences in the wealth of nations and the income of its citizens.

About the Bureau of Economic Analysis
(adapted from: www.bea.gov/bea/role.htm)

The Bureau of Economic Analysis (BEA) is an agency of the U.S. Department of Commerce. The BEA seeks to strengthen the understanding of the U.S. economy and its competitive position by providing accurate and relevant GDP and economic accounts data.

Although it is a relatively small agency, BEA produces some of the most closely watched economic statistics that influence the decisions made by government officials, business people, households, and individuals. The BEA's economic statistics, which provide a comprehensive, up-to-date picture of the U.S. economy, are key ingredients in critical decisions affecting monetary policy, tax and budget projections, and business investment plans. The creation of the statistical measure of GDP was recently recognized by the Department of Commerce as its greatest achievement of the 20th century and has been ranked as one of the three most influential measures that affect U.S. financial markets. The BEA prepares national, regional, industry, and international accounts that present essential information on such key issues as economic growth, regional economic development, interindustry relationships, and the nation's position in the world economy.

The BEA also prepares estimates of the nation's tangible wealth. The industry economic accounts provide detailed information on the flows of goods and services to industries for the production of gross output (input-output) and on the contributions by private industries and government to the nation's gross domestic product (GDP by industry). The regional economic accounts provide estimates and analyses of personal income, population, employment, and gross state product. The international economic accounts encompass the international transactions accounts (the balance of payments) and the estimates of U.S. direct investment abroad and foreign direct investment in the United States.

Questions

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   1,800
Federal government spending on goods and services   550
Construction of new homes   200
State and local spending on goods and services   1,300
Changes in inventories   - 300
Imports   1,500
Wages   6,000
  1. Given the following data (in billions of current dollars),
    1. what is the level of government spending in the calculation of GDP?
    2. what is the level of investment?
    3. what is the level of net exports?
    4. calculate the level of gross domestic product.
  2. If GDP has increased by 5 percent and inflation is 3 percent, what has happened to real GDP?
  3. If GDP increases by 5 percent and real GDP decreased by 2 percent, what has happened to the average price level?