Real Gross Domestic Product (GDP) during the first quarter (January through March) of 2004 increased at an annual rate of 4.4 percent. This is a .2 percent increase over the initial announcement one month ago.
Current Key Economic Indicatorsas of November 30, -0001
Real Gross Domestic Product (GDP) during the first quarter (January through March) of 2004 increased at an annual rate of 4.4 percent. This is a .2 percent increase over the initial announcement one month ago.
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:
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.
Real Gross Domestic Product (GDP) during the first quarter (January through March) of 2004 increased at an annual rate of 4.2 percent. This is the first release of the estimate and will be followed by two revisions over the next two months. This compares to rates of 8.2 and 4.1 percent in the previous two quarters.
The growth rates in real GDP in 2001, 2002, and 2003 were .3, 2.2, and 3.1 percent.
Meaning of the Announcement
The U.S. economy was in a recession during most of 2001 and experienced only modest growth in real GDP in 2002 and early 2003. The growth has increased significantly beginning in the middle of 2003, as real GDP increased at an annual rate of 6.1 percent over the last six months of the year.
Employment fell and unemployment increased for much of the time since the recession ended in November of 2001. Only in the last three months has employment started to rise at a pace greater than a pace that would simply keep unemployment rates steady.
Reasons for the Revision
The revision from 4.2 percent to 4.4 percent was due to higher estimates of inventory investment, state and local government spending, and exports. In addition, imports were revised upward and equipment and software investment spending were revised downward.
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 as a sign that the economy may have already come out of the recession that began in March of last year.
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 most recent recession.)
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 the last two quarters of 2000, the rate of growth of real gross domestic product slowed significantly (with a decrease in the third quarter of 2000). During the first three quarters of 2001, real gross domestic product fell as the U.S. economy entered a recession in March of 2001 lasting through November of 2001. The negative changes in real GDP were the first 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 and a stimulative fiscal policy helped increase consumer and investment spending during and since the recession.
Inflation remains low, but is and will continue to be of more concern to policy makers as the economy continues to grow. The price index for GDP increased at an annual rate of 2.6 percent during the first quarter of 2004, compared to an increase of 1.7 percent during 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, prior to the recession and over the last three quarters has been not only higher than in the first part 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. Increases in productivity, that is, output per hour worked, are the key to increases in real GDP per capita and therefore to increases in material standards of living.
Details of the First-Quarter Changes in Real GDP
The major contributors to the increase in real GDP in this quarter were the increases in consumption spending (3.9 percent), business investment (10.1 percent), and spending on national defense (13.2 percent). There were also small increases in exports and imports, together contributing to slower rise in real GDP.
Gross private domestic investment increased at an annual rate of 10.1 percent during the first quarter of 2004, compared to an increase of 14.9 percent in the last quarter of 2003. For all of 2003, investment spending increased by 4.2 percent.
First quarter exports increased by 4.9 percent (compared to a increase of 20.5 percent in the previous quarter) and imports increased by 5.9 percent (compared to an increase of 16.4 percent in the previous quarter). Thus net exports therefore fell slightly during the quarter.
GDP, Productivity, and Unemployment
A major factor in the continued growth in the American economy, as seen in the sound increase of 4.4 percent in real GDP in the first quarter, is the continued improvement in productivity.
Productivity, defined as the amount of output per hour of work, increased at an annual rate of 3.8 percent in the first quarter and 2.5 percent growth in the previous quarter. With rapid rates of increase in productivity, businesses are able to gain more output from the same or only a slight increase in the number of workers, boosting economic results. This explains how the economy was able to grow strongly in 2003 even as the unemployment rate stayed high and employment grew 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 most important cause of this productivity growth has been investment in information technology and software. This growth allowed the Fed to cut rates more than it would otherwise, as inflationary pressures are reduced. Alan Greenspan, the Chairman of the Federal Reserve System, 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.
What happens to employment if GDP increases by 7 percent in a year, inflation is equal to 2.6 percent, and productivity increases by 3.8 percent? Employment is likely to increase, decrease or stay the same?
[Decrease. The reasoning is that real GDP increases by approximately 4.4 percent. That is calculated by subtracting the rate of increase in prices from the rate of increase in GDP. Then if productivity increases by 3.8 percent, the economy needs .6 percent more workers to produce 4.4 percent more output. (Technically, .6 percent more hours of work are needed.)
This is approximately what happened to employment during the quarter. Employment did increase, but the numbers do not match exactly as the samples are from different surveys and have slightly different definitions. However, an understanding of how the basic concepts relate to one another is important.]
On November 26, 2001, the National Bureau of Economic Research (NBER) 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. More recently the NBER announced that the recession actually ended in November of 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 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 (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 ends of that recession and the most recent one were so difficult to determine was that 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.html
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 first 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.
- What happens to real GDP as consumption spending increases?
- What happens to consumption spending as real GDP increases?
- What is the difference or the similarity?
[The results are the same, but the difference is in causation. In the first case, consumption spending increases, and because it is part of GDP, real GDP increases. Consumers decisions to save less or a fall in taxes causes spending and then production to increase.
In the second, an increase in real GDP causes income and therefore consumption to increase. The increase in consumption is caused by the increase in income]
Revisions in GDP Announcements
Real GDP for each quarter is announced three times and often the revisions are significant. 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 announcement. While labeled as the final version, even it will eventually be revised after the final data for the year are published. Revisions in inventory investment and the international trade data are often the causes of changes in the real GDP figures. Since 1978, the advance estimates have been revised an average of 0.5 percent in the rate of growth of real GDP and the preliminary estimates have been revised by an average of 0.3 percent in the rate of growth of real GDP.
How should government spending on new roads and school buildings be treated? As consumption or investment? Some other way?
[Investment. An acceptable alternative is “Some other way.” Such spending is actually counted as part of government. However, because the new roads and buildings increase future capacity to produce, government investment increases. However, in the accounting for GDP, we count that as part of “government” not as part of “investment.”]
How should individual spending on college tuition be treated? As consumption or investment?Some other way?
[Investment. An acceptable alternative is “Consumption.” Such spending is actually counted as part of consumption as it done by individuals. However, because education increases future capacity to produce goods and services, it should be treated as investment.]
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 sound system produced and sold in the U.S. by a Chinese company
[Consumption – A stereo produced and purchased in the U.S. is counted as a consumption good and not an import, regardless of the ownership of the company.]
- College tuition
- 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 part of consumption, because it is the consumption of a good produced outside the U.S by a consumer in the U.S.]
- The purchase of a U.S. Treasury Bond by an individual
[Not included – The purchase of a U.S. 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 jacket made in Mexico and sold in the U.S.
[Imports and consumption – This is both an import and a consumption good, because it was produced outside the U.S. and purchased by a consumer in the U.S. 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 U.S. and sold in Canada
- A new interstate highway
Questions for Class Discussions
- If gross domestic product increases by three percent over a year, are we better off? Why or why not?
[It is not clear whether or not we are better off. The answer depends upon what is happening to prices and what is happening to population growth. If prices and population together are rising by more than three percent per year, than we, on average, are worse off. We have fewer goods and services per person. An example would be if we were experiencing three percent inflation and a one percent growth in population, real GDP per capita would have fallen over the year by one percent.]
- If consumers begin to purchase more automobiles manufactured in the U.S. instead of those manufactured abroad, what will happen to real GDP?
[Consumption spending will remain the same if the total spending on automobiles has not changed; however, imports will decrease. Real GDP in the U.S. will increase.]
- Why is income not included in gross domestic product?
[Gross domestic product includes all of the production of final goods and services in a year. Production of consumption, investment, government, and export goods and services are included.
Income is not added to the total amounts of production when calculating GDP. However, wages, salaries, dividends, profits, and rents are part of the costs on producing those goods and services and are thus indirectly included. An alternative way of calculating GDP is to add all of the income payments together.]