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Announcement

Real gross domestic product (GDP) during the first quarter (January through March) of 2005 increased at an annual rate of 3.1 percent. This is an advance estimate of the change in real GDP for the first quarter.

The increase in real GDP was primarily due to increases in consumption and inventory, software, equipment, and residential housing investment. Imports increased during the quarter.

Please do the following multiple choice activity:

Investment rises in a good sign for the future.
 
The entire year increase is a relatively high 4.4 percent increase in real GDP.

 

 

 

 

Meaning of the Announcement

Real gross domestic product increased during the first quarter (January through March) of 2005 increased at an annual rate of 3.1 percent. This is the first release of the estimate and is described as the advance estimate. This increase compares to rates of 4.0 and 3.8 percent in the previous two quarters. The growth rates in 2001, 2002, and 2003 were .8 percent, 1.9 percent, and 3.0 percent.

The U.S. economy experienced a recession in 2001 and had only modest growth in real GDP in 2002. Employment fell and unemployment increased for much of that time. Growth increased significantly in the middle of 2003, as real GDP increased at an annual rate of 5.8 percent over the last six months of the year, and has continued to grow at a relatively rapid pace.

The current announcement along with improving employment reports continues the good news. The major causes of the 3.1 percent increase in real GDP were the increases in investment and consumption. The effects of those increases in spending were somewhat offset by increases in imports.

Figure 1: Quarterly Changes in Real GDP at Annual Rates (1990-2004)

Interactive Question

GDP (in current prices) increased at an annual rate of 6.4 percent during the first three months. Given this information, what was the approximate increase in the level of prices in the economy during the quarter?

Please do the following multiple choice activity:

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.

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 most widely used definition by policy makers and economists includes measures of changes in industrial production, retail trade, employment, and real income.

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 third quarter of 2000 and the first and third 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 the 1991 recession.

The Federal Reserve responded to slowing growth and the recession by reducing the target federal funds rate twelve times from January 2001 to January 2003. (See the Federal Reserve and Monetary Policy Cases.) The effects of stimulative monetary policy and the resulting low interest rates helped increase investment and consumer spending during and since the recession.

As the economy recovered, the growth of real GDP increased and beginning in June 2004, the Federal Reserve began to be concerned with potential inflationary pressures. The target federal funds rate was raised eight times to a current level of 3.0 percent.

Figure 2: Annual Percentage Changes in Real GDP (1970-2004)

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 (3.1%), and the first half of the 1990s (2.3%).

In the last five years of the 1990s, the rate of growth in real GDP increased to 3.9 percent, with the last three years of the 1990s equaling an average of 4.4 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, somewhat offset by increases in imports. That pattern is identical to the results for this quarter. 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. The changes in productivity have had the most lasting effects on our average incomes.

Details of the First-Quarter Changes in Real GDP

Real GDP increased at an annual rate of 3.1 percent in the first quarter of 2005 compared to a rise of 3.8 percent in the fourth quarter of 2004. The major contributors to the increase in real GDP were the increase in overall investment of 12.5 percent, the increase in consumption spending of 3.5 percent, and the rise in exports of 7.0 percent. Government spending increased by .6 percent.

Increases in imports were 14.7 percent. This means that a portion of the increases in investment, consumption, and government spending were not spent on goods and services produced in the U.S. and thus did not add to real GDP here.

The price index for GDP increased at an annual rate of 3.1 percent during the first quarter of 2005, compared to increases at annual rates of 1.4 and 2.3 percent during the third and fourth quarters of 2004. Prices of all of GDP increased by 2.1 percent during all of 2004.

This increased rate of change in prices is becoming of some concern as the Federal Reserve continues to increase the target federal funds rate. (See the most recent Federal Reserve case study.)

GDP, Productivity, and Unemployment

A major factor in the continued growth in the American economy, as seen in the increase of 3.1 percent in real GDP growth 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 2.6% in the first quarter and 2.5 percent over the previous twelve months. 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. Real output and therefore real income per person is able to increase. The most important cause of this productivity growth has been investment in information technology and software.

This growth allowed the Federal Reserve to cut the target federal funds rate more than it otherwise would have during and following the 2001 recession and has reduced inflationary pressures in the recovery since.

The number of hours worked increased by 1.4 percent over the last 12 months. If productivity did not change, real GDP would have increased by 1.4 percent. However, with the 2.5 percent increase in output per hour, total output was able to increase by 3.8 percent (slightly different from the sum due to rounding).

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 2004.

  • Durable goods are items such as cars, furniture, and appliances, which are used for several years (8%).
  • 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 (41%).

Investment spending (I) consists of non-residential fixed investment, residential investment, and inventory changes. Investment spending accounts for 16 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 (6%).
  • 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 (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 spending now accounts for approximately 7 percent of GDP. Five percent of GDP is federal spending on defense.
  • 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 (15%).
  • Thus, net exports (exports minus imports) are negative, about 5% of the GDP.

Revisions in GDP Announcements

Real GDP for each quarter is announced in each of three months and often the revisions are significant. The month following the end of the quarter is described as the advance GDP; the next is a revision described at the preliminary announcement; and the third announcement is a revision labeled the final announcement. Even this final announcement will likely be revised in year end announcements and periodic reexaminations of the accuracy of the data.

The causes of the changes are often changes in inventory and international trade data – two particularly difficult estimates to make accurately in a quick fashion. This month the final estimate was the same as the preliminary estimate in the previous month.

GDP as a Measure of Well-Being

Changes in real GDP are a more accurate representation of meaningful economic growth than changes in GDP, because changes in real GDP represent changes in quantities produced, while prices are held constant. Change is GDP include changes in prices and quantities produced. 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 consume. 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 $1,417 billion, its GDP per capita is only $1,100. Hong Kong has a much smaller GDP of $176 billion. However, its GDP per capita is much higher at $25,860. England has a much larger GDP than Hong Kong, but only a slightly larger GDP per person. England's GDP is only slightly larger than China's, but with a much smaller population, England has a much higher per capita GDP.

2003 GDP in billions of current US dollars
(International Monetary Fund, World Bank)

Country

Population

GDP in billions

Per capita GDP

China

1,288,000,000

$1,417 billion

$1,100

Hong Kong

6,800,000

$176 billion

$25,860

United Kingdom

59,300,000

$1,680 billion

$28,320

Even 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 low GDPs per capita, while still quite low, underestimate their well-being.

Revisions in GDP Announcements

Real GDP for each quarter is announced in each of three months and often the revisions are significant. The month following the end of the quarter is described as the advance GDP; the next is a revision described at the preliminary announcement; and the third announcement is a revision labeled the final announcement. Even this final announcement will likely be revised in year end announcements and periodic reexaminations of the accuracy of the data.

The causes of the changes are often changes in inventory and international trade data – two particularly difficult estimates to make accurately in a quick fashion. This month the advance estimate and is normally subject to the largest revisions. The average revision of the advance estimate to next month's preliminary estimate is .5 percent. (This ignores the sign of the change.)

Use this table in order to help answer the following questions. (Note: Data is given in billions of current dollars.)

Consumption spending:
$10,000
Wages:
$11,000
Social security payments:
$500
State and local spending on goods and services:
$1,500
Incom tax receipts :
$2,000
Construction of new homes :
$500
Changes in inventories:
-$200
Exports:
$2,000
Business purchases of new factories and equipment:
$2,000
Federal government spending on goods and serivices:
$1,000
Imports:
$1,500