Explore the connection between the economic indicators and real-world issues. These lessons typically can be done in one class period.
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 10, 2014
The Consumer Price Index for All Urban Consumers increased 0.1 percent in October on a seasonally adjusted basis. The core inflation rate increased the same amount. For the previous 12 months, the index increased 1.7%, the same rate as reported in the September report.
According to the October report of the Bureau of Labor Statistics, the unemployment rate fell from 5.9% to 5.8%, and the number of individuals unemployed also decreased. Total nonfarm employment rose by 214,000 in October. Employment gains were concentrated in retail trade, food services and health care.
The advance estimate for real GDP growth in the third quarter of 2014 was 3.5%, a decrease from the revised second quarter growth of 4.6%. Inventory investment reduced third quarter growth, while it added to second quarter growth. In addition, consumer spending increased at a lower rate in the third quarter, compared to the second. Finally, business investment increased in the third quarter, but at a lower rate than in the second quarter.
The FOMC believes that the labor market has shown considerable improvement and the risks of inflation rising above its 2% target are low. Therefore, the Federal Reserve announced plans to end its purchase of financial assets. In addition, the federal funds rate will remain at its current low level. However, the FOMC has signaled its willingness to increase the federal funds rate if inflation shows signs of rising above the 2% target.
Real gross domestic product (GDP) during the first quarter (January through March) of 2005 increased at an annual rate of 3.8 percent. This is the final estimate of the change in real GDP for the first quarter. It is a revision of the preliminary estimate of a 3.5 percent increase in real GDP in the first quarter that was announced one month ago.
The increase in real GDP during the quarter was primarily due to increases in consumption, inventory, software, equipment, and residential housing investment, and exports. Imports also increased during the quarter.
Have students do this multiple choice quiz.
[Real GDP has been increasing since the second quarter of 2001 during the recession of 2001. Quarterly changes that were negative actually occurred during two quarters of 2000 and one quarter of 2001. The normal path for real GDP is to gradually increase over time. During recessions, real GDP will normally fall during one or more quarters.]
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 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.
Meaning of the Announcement
Real gross domestic product increased during the first quarter (January through March) of 2005 increased at an annual rate of 3.8 percent. This is the third release of the estimate and is described as the final estimate. This increase compares to rates of 4.0 and 3.8 percent in the previous two quarters. The growth rates in 2001, 2002, 2003, and 2004 were .8 percent, 1.9 percent, 3.0 percent, and 4.4.
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 beginning in the second quarter of 2003 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 3.8 percent increase in real GDP were the increases in consumption, investment, and exports. The effects of those increases in spending were somewhat offset by a 9.6 percent (at an annual rate) increase in imports.
The price index for all of GDP increased at an annual rate of 2.9 percent during the quarter. It increased at a rate of 2.1 percent for all of 2004.
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 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.
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 3.8 percent in the first quarter of 2005, the same as the increase in the fourth quarter of 2004. The major contributors to the increase in real GDP were the increase in overall investment of 10.9 percent, the increase in consumption spending of 3.6 percent, and the rise in exports of 8.9 percent. Government spending increased by .2 percent.
Increases in imports were 9.6 percent. This means that a portion of the increases in investment and consumption 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 2.9 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. The price index for GDP for all of 2004 increased by 2.1 percent.
This gradually increasing rate of change in prices has been becoming of some concern as the Federal Reserve continues to increase the target federal funds rate. (See the most recent Federal Reserve case study.)
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 policies 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.
[Correct answer. The reasoning is that if GDP increased by percent and prices increased by 2 percent, real GDP increased approximately by one percent - the difference between the increase in GDP and the price index. If the population growth was 1.5 percent, then actual real GDP per person or per capital decreased by approximately one-half of one percent.
For math classes and more advanced students, the more exact method of calculation is to multiply and divide. The change in real GDP would be found by dividing 1.03 by 1.02. Then to find the change in real GDP per capita, divide the result by 1.015. The result should be .995. That is that real per capita GDP is 99.5 percent of what it was or a decrease of .5 percent in real GDP per capita.]
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. The upward revision in the growth rate may even receive some special attention in the press. However, we should be careful in attaching too much importance to any one month change in the data.
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.
Are Estimates of GDP Accurate Measures of Our Well Being?
GDP fails to account for many forms of production that improve a person's well being. For example, if you make a meal at home, the labor is not included. However, if you were to go out to a restaurant and consume that same meal, the labor is included in GDP. Unpaid work at home or for a friend and volunteer work is not included and thus GDP does not reflect production of all we produce.
External effects of production, such as pollution, are not subtracted from the value of GDP. Although two countries may have similar GDP growth rates, one country may have significantly cleaner water and air, and therefore is truly better off than the other country. If as economic growth accelerates, producers begin to employ production techniques that create more pollution, the effects of the growth are overstated.
GDP includes police protection, new prisons, and national defense as goods and services. It is not always clear that if we have to devote increased resources for such purposes that we are better off as a result.
GDP includes the effects of price changes. An increase in GDP due solely to inflation does not signal an improvement in living standards. Real GDP is a better measure. Nor does GDP reflect population growth. Changes in the income distribution are not measured. It is also difficult to compare rates of growth for different countries, as countries use different means of estimating income and price levels in their economy.
There are a variety of other weaknesses and inaccuracies, but GDP accounting is the best that we have. Real GDP does provide sound signals as to the direction of change of a selected large part of what we produce each year. Government statisticians and academics are constantly working to improve its accuracy and its ability to reflect our well being.
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 as the preliminary announcement; and the third announcement is a revision labeled the final announcement. Even this final announcement will likely be revised again with 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 is the final estimate is .3 percent higher than the preliminary estimate of one month ago. The preliminary estimate was .4 percent higher than the advance estimate. The current revision occurred primarily due to an upward adjustment in the increase in exports and an increase in housing investment.