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 third quarter (July through September) of 2003 increased at an annual rate of 8.2 percent.
Notes to 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.
You may wish to use the following larger versions of the graphs and tables from this lesson for overhead projection or handouts in class:
|Consumption rises more than previously announced||Forecast for the entire year is for a 4.3 percent increase|
Meaning of the Announcement
The U.S. economy experienced a recession in 2001 and experienced only modest growth in real GDP since. Employment has fallen and unemployment has increased for much of the time since the recession ended in November of 2001. The current announcement along with improving employment reports is good news. However, we should be cautious with the results of any single quarter. (Real GDP did increase as much as 5.0 percent in the first quarter of 2002, only to fall to significantly lower rates of increase since.)
Consensus forecasts are the real GDP will increase by about 4 percent in the fourth quarter, bringing the 2003 increase to approximately 4.3 percent. The average forecast for 2004 is a 4 percent increase in real GDP.
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 rates of change in real GDP and the accompanying related data in the U.S. economy;
- descriptions of major issues surrounding the data announcements;
- brief analyses of historical perspectives;
- questions and activities to use to reinforce and develop understanding of relevant concepts; and
- 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.
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 inflation and unemployment rates and changes in our income distribution provide us additional measures of the successes and weaknesses in our economy, none is a more important indicator of our economy's health than the rate 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. The current increase in real GDP is discussed in news reports as a sign that the economy is growing and may well continue to do so. (There also is considerable concern with lagging growth in employment. See the latest unemployment case.)
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.
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 lasting through November 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 and then two more times since. The most recent was in June of 2003. (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 an annual rate of 1.6 percent during the third quarter of 2003, compared to an increase of 1.1 percent during the second quarter of 2003. It increased at an annual rate of 1.5 percent for 2002, compared to 2.4 percent for 2001.
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.
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 8.2 percent in the third quarter of 2003 compared to a rise of 3.1 percent in the second quarter of 2003. The major contributor to the increase in real GDP was the increase in consumption spending and business and housing investment. There were also small contributions from increases in exports and government spending.
Gross private domestic investment increased at an annual rate of 14.8 percent during the third quarter of 2003, compared to an increase of 4.7 percent in the second quarter of 2003. For all of 2002, investment spending decreased by 1.2 percent.
Third quarter exports increased by 9.9 percent (compared to a decrease of 1.1 percent in the second quarter) and imports increased by .8 percent (compared to an increase of 9.1 percent in the second quarter).
GDP, Productivity, and Unemployment
A major factor in the continued growth in the American economy, as seen in the strong increase of 8.2% real GDP growth in the third quarter, is the continued improvement in productivity. (See the most recent Productivity case study). Productivity, defined as the amount of output per hour of work, increased at an annual rate of 9.4% in the third quarter and 7.0% growth in the second quarter. Businesses are able to gain more output from the same number of workers, boosting economic results. This explains how the economy continues to grow strongly even as the unemployment rate stays high and employment grows only slowly.
The Federal Reserve has stated in its recent releases that continued productivity growth is a key component in the continued growth in the American economy. Businesses are able to keep costs low by reducing the need to hire new employees to create growth. The biggest cause of this productivity growth has been investment in information technology and software. This growth has allowed the Fed to cut rates more than it would otherwise, as inflationary pressures are reduced. Alan Greenspan has repeatedly cited productivity growth and was one of the first to view the 1990’s boom in technology spending as a period of sustainable growth above historical levels. Eventually, continued productivity and economic growth will spur new investment and hiring.
If real GDP increases by 8.2 percent and productivity increases by 9.4 percent, what should be happening to the approximate number of hours worked in the economy?
- increase by 1.2 percent
- decrease by 1.2 percent
- increase by 9.4 percent
- decrease by 9.4 percent
- increase by 8.2 percent
[Correct answer. B. If output rises at rate of increase that is slower than the increase in output per hour, than the number of hours must have been decreasing. An approximate measure of the amount is to subtract the rate of increase in productivity from the rate of growth in output. (The actual number do not match exactly as productivity, real GDP, and hours worked are taken from slightly different samples.)]
A recession began in March of 2001 and ended in November of that year. Much of the discussion in the economic news since has focused on a rather slow return to economic growth rates that we experienced in the late 1990s.
The National Bureau of Economic Research, the agency that determines the official beginning and end of recessions, 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 data show a decline in employment, but not as large as in the previous recession. Real income growth declined. Manufacturing and trade sales and industrial production both declined.
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 70 percent of GDP in the third quarter.
- Durable goods are items such as cars, furniture, and appliances, which are used for several years (9%).
- Non-durable goods are items such as food, clothing, and disposable products, which are used for only a short time period (21%).
- 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 (41%).
Investment spending (I) consists of non-residential fixed investment, residential investment, and inventory changes. Investment spending accounts for 15 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 (5%).
- Inventory changes consist of changes in the level of stocks of goods necessary for production and finished goods ready to be sold (0%).
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 (19%) 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.
Net Exports (NX) is equal to exports minus imports. Exports are items produced in the U.S. and purchased by foreigners (10%). Imports are items produced by foreigners and purchased by U.S. consumers (14%). Thus, net exports (exports minus imports) are negative, about -4% of the GDP.
1. Given the following data (in billions of current dollars),
- what is the level of government spending in the calculation of GDP?
[Government spending equals $1,900 ($600 plus $1,300).
Government spending is equal to the sum of federal spending on goods and services and state and local spending on goods and services. Social security payments are transfers of income from tax payers to social security recipients and do not represent the production of goods and services.]
- what is the level of investment?
[Investment equals $2,200 ($1,800 + 500 - 100).
New factories and equipment and construction of new homes are included in investment. However, since business inventories fell, we subtract $300 billion from investment in structures, equipment, and residential housing to get the investment portion of GDP.]
- what is the level of net exports?
[Net exports equal a minus $300 ($1,500 - 1,800).
Net exports are exports minus imports. In this case, the economy has a balance of trade deficit.]
- calculate the level of gross domestic product.
[GDP equals $11,800 billion ($8,000 + 1,900 + 2,200 - 300).
GDP equals consumption spending plus government spending on goods and services plus investment spending plus net exports.]
|Social security payments||500|
|Income tax receipts||1,000|
Business purchases of new factories and equipment and changes in inventories
Federal government spending on goods and services
|Construction of new homes||500|
State and local spending on goods and services
|Changes in inventories||- 100|
- If GDP has increased by 8 percent and inflation is 1 percent, what has happened to real GDP?
[Real GDP increased by 7 percent. If nominal GDP has increased by 8 percent and prices have increased by 1 percent, than real GDP has increased by the difference – 7 percent.]
- If GDP decreases by 1 percent and real GDP increases by 3 percent, what has happened to the average price level?
[Price must have decreased by 4 percent, in this case an instance of deflation. If nominal GDP decreases by 1 percent while the amount of output increases by 3 percent, then prices must have decreased by 4 percent. (This instance is an unusual combination of deflation and rise in output.)]
Other Questions for Students
- If gross domestic product increases by 1 percent over a year, are we better off? Why or why not?
[Perhaps we are better off, but it is unlikely. 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 1 percent per year, than we, on average, are worse off. We have fewer goods and services per person. It is highly likely that at any one time prices are rising more rapidly than 1 percent (an annual rate of 1.6 percent in this announcement) and that population is rising by about 1 percent per year.]
- If consumers begin to purchase automobiles manufactured in the U.S. instead of those manufactured abroad, what will happen to real GDP? Will the answer be different if consumers are simply increasing their spending and not reducing their spending abroad?
[Consumption spending will remain the same; however, imports will decrease. Real GDP in the U.S. will increase as production increases. In the second instance, consumption spending increased, but imports do not change. Real GDP does change, as consumption rises.]
- 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.]