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INTRODUCTION

This lesson focuses on the monthly report on Real Gross Domestic Product (Real GDP), produced by the U.S. Bureau of Economic Analysis (BEA). The current data and historical data are explained. The meaning of GDP and potential impacts of changes of GDP are explored. This focus on economic data will also raise the question about a potential recession in the United States in 2008.

The Bureau of Economic Analysis (BEA) Announcement: January 30, 2008

'Real gross domestic product, the output of goods and services produced by labor and property located in the United States, increased at an annual rate of 0.6 percent in the fourth quarter of 2007 (October-December), according to advance estimates released by the Bureau of Economic Analysis. In the third quarter, real GDP increased 4.9 percent.

The Bureau emphasized that the fourth-quarter 'advance' estimates are based on source data that are incomplete or subject to further revision by the source agency. The fourth-quarter 'preliminary' estimates, based on more comprehensive data, will be released on February 28, 2008.

TASK

  • Review the January 30, 2008, BEA report on real gross domestic product (Real GDP) and determine the recent and historical rates of growth of the U.S. economy.
  • Determine the difference between nominal and real measurements of gross domestic product.
  • Identify the components of the measurement gross domestic product

PROCESS

Real Gross Domestic Product Growth, Fourth-Quarter, 2007

The Bureau of Economic Analysis (BEA) Announcement: January 30, 2008

'Real gross domestic product, the output of goods and services produced by labor and property located in the United States, increased at an annual rate of 0.6 percent in the fourth quarter of 2007 (October-December), according to advance estimates released by the Bureau of Economic Analysis. In the third quarter, real GDP increased 4.9 percent.'

The Bureau emphasized that the fourth-quarter 'advance' estimates are based on source data that are incomplete or subject to further revision by the source agency. The fourth-quarter 'preliminary' estimates, based on more comprehensive data, will be released on February 28, 2008.

2007 Real Gross Domestic Product Growth

The BEA also announced the change in GDP for the full year of 2007.

'Real GDP increased 2.2 percent in 2007 (that is, from the 2006 annual level to the 2007 annual level), compared with an increase of 2.9 percent in 2006.

The major contributors to the increase in real GDP in 2007 were personal consumption expenditures (PCE), exports, nonresidential structures, and state and local government spending. These positive contributions were partly offset by decreases in residential fixed investment and in inventory investment. Imports, which are a subtraction in the calculation of GDP, increased.

The deceleration in real GDP primarily reflected a larger decrease in residential fixed investment, a downturn in private inventory investment, and a deceleration in equipment and software that were partly offset by a deceleration in imports.

The price index for gross domestic purchases increased 2.7 percent in 2007, compared with an increase of 3.3 percent in 2006.

Current-dollar GDP increased 4.9 percent, or $648.3 billion, in 2007. Current-dollar GDP increased 6.1 percent, or $760.8 billion, in 2006.

During 2007 (that is, measured from the fourth quarter of 2006 to the fourth quarter of 2007), real GDP increased 2.5 percent. Real GDP increased 2.6 percent during 2006. The price index for gross domestic purchases increased 3.3 percent during 2007, compared with an increase of 2.4 percent during 2006.'

Real GDP Growth - Quarterly and Annual Rates

Rates of change in GDP figures are reported for years and quarters. When the quarterly rates of increase are reported, they are reported as though the changes at occurred for an entire year. If the rate of growth during the first quarter of the year had continued for an entire year, real GDP would have been seven-tenths of one percent higher. (The actual growth rate during the quarter was approximately one-fourth of .7 percent or slightly over .17 of one percent.) This means that for all practical purposes, there was practically no growth in real GDP in the quarter.

Reporting at annual rates makes it easier to compare the change in a quarter to the change of another quarter and to the change over an entire year.

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.

Determining Real Gross Domestic Product

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.

GDP Data Trends

Following the 2001 recession, growth in real GDP increased by 1.6 percent in 2002, 2.5 percent in 2003, and 3.6 percent in 2004. The annual rate of growth decreased sligtly to 3.1 percent in 2005 and 2.9 percent in 2006. Growth in the first quarter of 2007 was very slow, but increased over trhe next two quarters to 3.8 and 4.9 percent. The 0.6 percent rate of growth in the fourth quarter of 2007 is the lowest since the fourth quarter of 2002.

The reports of the rates of growth over the last twelve months have been erratic, from slightly less than one percent in the first-quarter to 4.9 percent in the third quarter. 2007 ended with the slowest growth of any twelve-month period since 2002-2003. Figure 1 and Table 1 illustrate recent chagnges in US Real GDP growth.

figure1

According to the January 30, 2008, BEA report:

'The increase in real GDP in the fourth quarter primarily reflected positive contributions from personal consumption expenditures (PCE), nonresidential structures, state and local government spending, exports, and equipment and software that were largely offset by negative contributions from private inventory investment and residential fixed investment. Imports, which are a subtraction in the calculation of GDP, increased slightly.

The deceleration in real GDP growth in the fourth quarter primarily reflected a downturn in inventory investment and decelerations in exports, in PCE, and in federal government spending that were partly offset by a deceleration in imports and an acceleration in state and local government spending.'

Real GDP Per Capita (per person)

The meaning of GDP may be more meaningful when expressed relative to nation's polulation, called Real Per Capita GDP. China, for instance has a large GDP compared to most nations. But, when China's GDP is expressed 'per capita,' it is much smaller than many nations.

Nominal GDP Rank Per Capita Rank GDP (2006)

U.S $13,194,700 (millions) 2 $45,594 9
China $2,644,692 (millions) 4 $2,460 104

* The European Union is 1st with a GDP of $14,609,863 (millions)

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. A popular definition of a recession is at least two consecutive quarters of declining real GDP.

Long-run Trends

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. Growth slowed in the beginning of the 2000s, but rebounded and averaged 3.5 percent on an annual basis for the 2003 through 2006 period. The rate of growth declined in 2007.

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.

figure2

The longer run rate of growth of 3.1 percent has most recently been caused by a one percent increase in the number of people working and about a two percent increase in productivity of each worker. During the periods prior to the 1990s, the productivity increase contribution was slightly less than two percent and the labor force growth part slightly higher than one percent.

Prices

The price index for gross domestic purchases, which measures prices paid by U.S. residents, increased 3.8 percent in the fourth quarter, compared with an increase of 1.8 percent in the third. Excluding food and energy prices, the price index for gross domestic purchases increased 2.5 percent in the fourth quarter, compared with an increase of 1.9 percent in the third. It increased at an average annual rate of 2.9 percent for all of 2004, 2005, and 2006. See the latest inflation focus on economic data for a discussion of the recent increases in price levels.

The Federal Open Market Committee pays particular attention to the portion of the GDP index that focuses on consumption purchases and in particular that index that excludes purchases of energy and food items. This is an effort to use a broader index than just the core CPI. The FOMC believes that this index also more accurately reflects trends in prices. See the latest FOMC focus on economic data for more information.

Details of the First-Quarter Changes in Real GDP

The increase in real GDP in the fourth quarter primarily reflected positive contributions from personal consumption expenditures (PCE), nonresidential structures, state and local government spending, exports, and equipment and software that were largely offset by negative contributions from private inventory investment and residential fixed investment. Imports, which are a subtraction in the
calculation of GDP, increased slightly.

The deceleration in real GDP growth in the fourth quarter primarily reflected a downturn in inventory investment and decelerations in exports, in PCE, and in federal government spending that were partly offset by a deceleration in imports and an acceleration in state and local government spending.

Final sales of computers contributed 0.18 percentage point to the fourth-quarter growth in real GDP after contributing 0.28 percentage point to the third-quarter growth. Motor vehicle output subtracted 0.90 percentage point from the fourth-quarter growth in real GDP after contributing 0.36 percentage point to the third-quarter growth.

The Role of Productivity

A major factor in the long-term growth in the American economy is continued improvement in productivity. Business sector productivity grew at an annual rate of 6.7 percent during the third quarter of 2007, the largest gain since a 9.1 percent increase in the third quarter of 2003 (seasonally adjusted annual rates).

Output rose 5.7 percent, the largest increase since a 10.4 percent rise in the third quarter of 2003. Hours of all persons engaged in the sector fell 1.0 percent, the first decline in the series since the second quarter of 2003, when hours fell 2.2 percent. When the third quarter of 2007 is compared to the third quarter of 2006, productivity rose 2.9 percent. This is the largest four-quarter increase since output per hour grew 3.4 percent from the second quarter of 2003 to the second quarter of 2004.

With productivity increases, businesses are able to gain more output from the same number of workers. But businesses also need more workers. If real GDP grows faster than the increase in productivity, more workers are needed to produce the real GDP and employment will rise in the quarter. If output rises more slowly than the rise in productivity, than fewer workers or fewer hours of work will be needed to produce the real GDP.

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.

Is the U.S. Headed for a Recession?

Slowing growth in the United States has caused many economists and business leaders to predict that the U.S. will enter a recession soon. Some think that we are already in one.

The National Bureau of Economic Research (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.' Generally this means that a period of two consecutive quarters of negative growth will be identified as a recession.

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.

Recent U.S. 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 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 rapidly even after it came out a period of falling output and income.

A Note 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

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 11 percent of GDP.
  • Imports are items produced by foreigners and purchased by U.S. consumers are equal to about 17 percent of GDP. Net exports (exports minus imports) are negative and are about 6 percent of the GDP.

Revisions in GDP Announcements

Real GDP for each quarter is announced three times. The month following the end of the quarter is described as the advance real GDP; the second announcement or revision is described as the preliminary announcement; and the third month (this one) is the final revision. While labeled as the final version, even it will eventually be revised after the final data for the year are published. From 1983 to 2002, the advance estimates of the rate of growth in real GDP have been revised an average of 0.5 percent in the next month's preliminary estimate. The preliminary estimates have been revised by an average of an additional 0.3 percent.

Revisions in inventory investment and the international trade data are often the causes of changes in the GDP figures. Those data for the last month of the quarter are not available when the advance estimate of GDP is announced and only initial estimates are available at the time of the preliminary estimate. In the current quarter, the revision was primarily due to larger increases in exports.

Full Employment Real GDP

Economists define the approximate unemployment rate, at which there are not upward or downward pressures on wages and price, as full employment rate of unemployment. If unemployment falls to level below the full employment rate, there will be upward pressure on wages and prices. If unemployment rises to a very high rate, there will downward pressure on wages and prices or wages and prices will remain steady. In the middle is a level, or more likely a range, where there is not pressure on wages and prices to rise or fall.

The level of real GDP that can be produced at that rate of unemployment is described at the full employment level of real GDP. Sometimes it is described as the potential level of real GDP. It is the highest level that an economy can produce at any given time without causing significant inflation.

How can we increase economic growth over time?

Economic growth is a function of the technological innovation and the amount and quality of labor and capital in the economy:

As more people are employed, the amount of capital increases, education levels increase, the quality of capital changes, or the technology increases, the productive capacity of the economy increases. Therefore, the economy can increase its output giving consumers more disposable income, promoting an increase in consumption spending, and providing resources for business to use for further investment and government to use to provide public goods and services.

Increased labor force participation increases output. Expanded, improved education creates more productive workers. Business and government spending on research and development enhance our abilities to produce and allow each worker to become more productive, increasing incomes for all.

Finally, to achieve a higher level of GDP in the future, consumers need to limit consumption spending and increase savings today, permitting businesses to invest more in capital goods. If resources are invested into building an economy now, future generations will enjoy a higher level of economic growth; our businesses will produce more goods and consumers can purchase more goods. Expansion of output at rates faster than our population growth is what gives us the opportunity to enjoy higher standards of living.

Economic Policy Options

There are two types of policies government can use to stimulate the economy (or slow it down). Policy actions to stimulate growth are referred to a 'expansionary' policies. Policy actions to slow the economy are referred to a 'contractionary' policies.

Monetary Policies

Monetary policies are those that influence the supply of money or interest rates in the economy. These policies are tools of the Federal Reserve System. The Federal Reserve determines policies through the Federal Open Marker Committee (FOMC). The FOMC consists of twelve members--the seven members of the Board of Governors of the Federal Reserve System; the president of the Federal Reserve Bank of New York; and four of the remaining eleven Reserve Bank presidents, who serve one-year terms on a rotating basis.

The FOMC holds eight regularly scheduled meetings per year. At these meetings, the Committee reviews economic and financial conditions, determines the appropriate stance of monetary policy, and assesses the risks to its long-run goals of price stability and sustainable economic growth.

  • Open Market Operations - the buying or selling of government securities in the 'open market.'
  • Discount Rate - the interest rate charged by the Federal Reserve Banks to member banks.
  • Reserve Requirements - The percentage of deposits banks must keep on reserve in their vaults or in accounts in the federal Reserve Banks. A banks ability to make loans is increases when it has more excess reserves.

A Note on the Federal Funds Rate

In the news, you will read that the Federal Reserve has set a target for the federal funds rate or desired quantity of reserves.

Using its monetary policy tools, the Federal Reserve can influence the demand and supply of balances that depository institutions hold at Federal Reserve Banks. This will alter the federal funds rate. The federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight.

Changes in the federal funds rate affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit, and, ultimately, a range of economic variables, including employment, output, and prices of goods and services.

Fiscal Policies

Fiscal policies are the use of government revenues (spending or taxes) to expand or contract the economy.

  • Spending - The Federal government can increase spending to stimulate the economy or decrease spending to slow it down.
  • Taxes - The federal government can increase taxes to slow the economy or decrease taxes to stimulate the economy.

Stagflation

In response to the Real GDP announcement and recent increases in the price level, Ethan S. Harris, chief Unites States economist for Lehman Brothers said, 'the one word description of this report is 'stagflation,' in a New York Times interview. Stagflation refers to a time when there is inflation and unemployment in the economy at the same time.

In the past, the theory was that inflation and unemployment would not happen at the same time - the so-called 'Phillips Curve' concept first identified by economist Alban Phillips. The idea was that increased unemployment would abate inflationary pressures and that policies to reduce one would tend to increase the other. This theory was largely abandoned in the 1970s when we experienced both inflation and unemployment at the same time and the term stagflation was coined by United Kingdom Chancellor of the Exchequer Iain MacLeod in 1965. In the 1990s, the United States experienced very low inflation and very low unemployment at the same time.

Stagflation creates conflict for many policy makers who fear that anti-inflationary policies will increase unemployment and that expansionary policies monetary ands fiscal policies might contribute to inflation.

CONCLUSION

Summary:

  • U.S. Real gross domestic product increased at an annual rate of 0.6 percent in the fourth quarter of 2007, according to advance estimates released by the Bureau of Economic Analysis.
  • For the year 2007, Real GDP increased 2.2 percent from the 2006 annual level, compared with an increase of 2.9 percent in 2006.
  • The rate of growth of the U.S. economy has been slowing over the last few years. If GDP growth stops or declines of atleast six months, the U.S. may enter a recession.
  • Time will tell if recent Federal Reserve FOMC actions to reduce the target fed funds rate and tax rebates to pump more funds into the economy will stimulate growth.
  • Also remember that the Federal Reserve's primary policy target has recently been inflation. Any inflationary pressure that results from expansionary policies may have to be dealt with later.

ASSESSMENT ACTIVITY

Click the start button below to complete an online interactive about the GDP lesson.

Write a one or two paragraph response to this prompt:
 

 

  1. U.S real gross domestic product increased at an annual rate of 0.6 percent in the fourth quarter of 2007, after a third quarter real GDP increased of 4.9 percent. If this is a sign that the U.S. nearing a recession, what should economic policymakers do?
     
  2. How will those actions affect the economy?

EXTENSION ACTIVITY

Discussion Questions:

  1. How will a decline in GDP affect the average person?
  2. What groups are more or less affected by an economic downturn or a recession?
  3. Is the U.S. entering a recession?