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Announcement

Real Gross Domestic Product (GDP) during the fourth quarter (October, November, and December) of 2005 increased at an annual rate of 1.6 percent. This is the second estimate of the rate of change in the fourth quarter.

This is also the second estimate of the growth in real gross domestic product for the entire year of 2005. Real GDP for the entire year increased at a rate of 3.5 percent.

This quarter's increase compares to annual rates of 3.3 and 4.1 percent in each of the first two previous quarters. For the entire 2005 year, real GDP increased at a rate of 3.5 percent. During all of 2005, real GDP increased by 3.5 percent. Annual growth rates in 2002, 2003, and 2004 were 1.6, 2.7, and 4.2 percent.

This is a revision upward in the number that was reported in the advance estimate. A larger increase in investment spending and a smaller decrease in government spending were primarily responsible for the revised overall growth.

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.

There are often a number of different measures of GDP reported. Nominal GDP, or simply GDP, is total output in current prices. Real GDP is total output with prices held constant. Real GDP per capita is the real GDP per person in the economy and is the best measure of well-being of all the other measures.

One approximate means of calculating real GDP per capita is to identify the increase in nominal GDP and then subtract the percentage increase in prices and the percentage increase in population. That would leave the percentage increase in real GDP per capita.

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.

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 positive sign of the strength of the current economy.

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.

Data Trends

During 2000 and 2001, the rate of growth of real gross domestic product slowed significantly. A recession was declared for March 2001 to November 2001. Growth increased in 2002, 2003, and 2004, reaching 4.2 percent in 2004. The most recent quarter's growth rate is relatively small. All of the quarterly growth rates in the previous 10 quarters were above 3 percent annual rates. We would have to go back to the fourth quarter of 2002 to find slower growth than in this quarter.

The Federal Reserve responded to slowing growth and the 2001 recession by reducing the target federal funds rate by 475 basis points (4.75%) from January 2001 to December 2001 (and then again by another .5 percent in November 2002 and another .25 percent in June of 2003). (See the 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. As the economy began to grow, the Federal Reserve reversed its policy to slow the growth to a sustainable level and has been increasing the target federal funds rate since.

Graph 1

Long-run Trends

The rate of increase in real GDP was not only higher in the last part of the 1990s than in the first half 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.

Graph 2

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. Figure 2 shows the history of growth since the 1970s. Figure 2 also shows the average annual rate of growth of 3.1 percent since 1970.

Prices

The price index for GDP increased at an annual rate of 3.3 percent during the fourth quarter of 2005, compared to the rate of increase of 3.3 percent during the third quarter of 2005. It increased at an annual rate of 2.8 percent for all of 2005. See the latest inflation case study for a discussion of the recent increases in price levels.

Details of the Third-Quarter Changes in Real GDP

Real GDP increased at an annual rate of 1.6 percent, a slowdown in growth. The major contributors to the decrease in the growth rate of real GDP in the fourth quarter were a significant slowing in the growth of in personal consumption and a fall in government spending, with a decrease in national defense spending. Those factors slowing growth were partially offset by an increase in investment.

GDP, Productivity, and Unemployment

A major factor in the long-term growth in the American economy is continued improvement in productivity. Productivity increased at an annual rate of 2.9 percent in 2005. Businesses are able to gain more output from the same number of workers. This explains how real GDP can increase at the same time employment is falling. If real GDP grows faster (3.5%) than the increase in productivity (2.9%), more workers are needed to produce the real GDP. If unemployment is to fall, spending and output in the economy will have to grow faster than the increase in productivity.

The Federal Reserve has stated in many of its recent releases that continued productivity growth is a key component in the continued growth in the American economy. Businesses are able to expand production more rapidly than the growth in employment and thus, the most important consequence, real GDP per capita can increase.

Recessions

On November 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 signaled the official beginning of a recession. In July 2003, the committee reported its determination of the end of the recession as of November 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 current data show a decline in employment, but not as large as in the previous recession. Real income growth slowed but did not decline. Manufacturing and trade sales and industrial production both declined and had been doing so for some time.

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. 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, very similar conditions to those of the current economy.

For the full press release from the National Bureau of Economic Research see:
[EEL-link id='1751' title='www.nber.org/cycles/recessions.html' ]

Explanations of GDP and its Components

Gross domestic product consists of goods and services produced for consumption, for investment, for government, and for export. The GDP accounts are broken down into consumption spending, investment spending, government spending, and spending on U.S. exports. To arrive at the amount actually produced (that is, GDP) our spending on imports is subtracted from those other amounts of spending. Thus,

GDP = Consumption spending + investment spending + government spending + export spending - import spending

Consumption spending consists of consumer spending on goods and services. It is often divided into spending on durable goods, non-durable goods, and services. These purchases currently account for 70 percent of GDP.

  • Durable goods are items such as cars, furniture, and appliances, which are used for several years.
  • Non-durable goods are items such as food, clothing, and disposable products, which are used for only a short time period.
  • 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.

Investment spending 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.
  • Residential investment is the building of a new homes or apartments.
  • Inventory changes consist of changes in the level of stocks of goods necessary for production and finished goods ready to be sold.

Government spending 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 percent) 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, while federal spending is 7 percent of GDP.

Exports are goods and services produced in the U.S. and purchased by foreigners - currently about 10 percent of GDP.

Imports are items produced by foreigners and purchased by U.S. consumers are equal to 16 percent of GDP. Net exports (exports minus imports) are negative and are about 6 percent of the GDP.

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.

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

Sources: Population numbers, year 2000, [EEL-link id='1135' title='www.worldbank.org' ] ,
GDP, 2001, [EEL-link id='1752' title='www.imf.org/external/index.htm' ]

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.

Interactive questions

Use this table to help answer the questions in the following interactive activity. (Measured in billions of current dollars.)

Social security payments
$1,000
Income tax receipts
1,500
Exports
2,100
Wages
9,000
Consumption spending
8,000
Federal government spending on goods and services
750
Construction of new homes
400
State and local spending on goods and services
1,250
Changes in inventories
- 500
Imports
2,500
Business purchases of new factories and equipment
2,000