Gross Domestic Product s1

A CASE STUDY Gross Domestic Product

Fourth Quarter, 2004

Date of Announcement

March 30, 2005

Date of Next Announcement

April 28, 2005 (The advance announcement for the first quarter of 2005.)

Announcement

Real gross domestic product (GDP) during the fourth quarter (October through December) of 2004 increased at an annual rate of 3.8 percent. The increase in real GDP for the entire year of 2004 was 4.4 percent.

Interactive question. An increase

Is this rate of change high relative to the annual changes in the previous three years? A decrease

No change

Answer. (This should pop up.)

An increase

This increase in relatively high compared to the last three years. During 2004, real GDP increased by 4.4 percent. The annual growth rates for the previous three years were .8 percent, 1.9 percent, and 3.0 percent.

Attention Teachers

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.

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

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 last quarter (October through December) of 2004 increase at an annual rate of 3.8 percent. This is the third and final release of the estimate. This increase compares to rates of 3.3 and 4.0 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. The 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 cause of the 3.8 percent increase in real GDP was the increase in investment. A smaller increase in consumption also added to the growth. Those increases were somewhat offset by increases in imports.

2 Figure 1

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

3 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 2001 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 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 seven times to a current level of 2.75 percent.

Figure 2

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. That is the same rate as the growth over all of 2004. 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. 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 Fourth-Quarter Changes in Real GDP

Real GDP increased at an annual rate of 3.8 percent in the fourth quarter of 2004 compared to a rise of 4.4 percent in the third quarter of 2004. The major contributors to the increase in real GDP were the increase in overall investment of 13 percent and the

4 increase in consumption spending of 4.2 percent. Rises in imports (11.4 percent) did reduce the overall growth rate. Exports grew at 3.2 percent and government increased by .9 percent. The price index for GDP increased at an annual rate of 2.4 percent during the fourth quarter of 2004. It increased at a rate of 2.2 for all of 2004. The increases in 2002 and 2003 were 1.7 and 1.8 percent. While inflation is not a problem, the Federal Reserve is increasingly sensitive to the possibility of increased inflationary pressures in the near future.

GDP, Productivity, and Unemployment

A major factor in the continued growth in the American economy, as seen in the strong increase of 3.8 percent in real GDP growth in the fourth quarter, is the continued improvement in productivity. (See the most recent Productivity case study). Productivity, defined as the amount of output per hour of work, increased at an annual rate of 2.1% in the fourth quarter and 2.8 percent over the previous twelve months. Increases in productivity allow businesses to gain more output from the same number of workers, boosting economic results. With productivity increasing at a rate of 2.1 percent and the number of hours worked increasing at 1.6 percent, total output can increase at the 3.8 percent rate of the fourth quarter. 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 Federal Reserve to cut the target federal funds rate more than it otherwise would have in the 2001 recession and reduced inflationary pressures in the recovery since. Alan Greenspan 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 even more new investment and hiring.

Interactive question

What happens to employment if GDP increases by 7 percent in a year, inflation is equal to 3 percent, and productivity increases by 3 percent?

Employment is likely to:

Increase Decrease Stay the same

Pop-up answer- Increase

5 Correct answer. The reasoning is that while GDP increases by 7 percent, prices have gone up by 3 percent. Thus real GDP has increased by approximately 4 percent. If the output per hour has increased by 3 percent, than the number of hours must have increased by 1 percent. That may have been due to an increase in employment of 1 percent or perhaps just an increase in the number of hours of current workers.

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

6 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.

Interactive questions for students.

1. Given the following data (in billions of current dollars),

a. what is the level of government spending in the calculation of GDP?

b. what is the level of investment?

c. what is the level of net exports?

7 d. calculate the level of gross domestic product.

Consumption spending $8,000 Social security payments 500 Income tax receipts 1,000 Exports 1,500 Business purchases of new factories and equipment and changes in inventories 1,800 Federal government spending on goods and services 600 Construction of new homes 500 State and local spending on goods and services 1,300 Changes in inventories - 100 Imports 1,800 Wages 6,000

2. If GDP has increased by 8 percent and inflation is 1 percent, what has happened to real GDP?

3. If GDP decreases by 1 percent and real GDP increases by 3 percent, what has happened to the average price level?

Answers to interactive questions.

1. a. Government spending equals $1,900 ($600 plus $1,300).

Government spending is equal to the sum of federal spending on goods and services and state and local spending on goods and services. Social security payments are transfers of income from tax payers to social security recipients and do not represent the production of goods and services.

b. Investment equals $2,200 ($1,800 + 500 - 100).

New factories and equipment and construction of new homes are included in investment. However, since business inventories fell, we subtract $300 billion from investment in structures, equipment, and residential housing to get the investment portion of GDP.

c. Net exports equal a minus $300 ($1,500 - 1,800).

Net exports are exports minus imports. In this case, the economy has a balance of trade deficit.

d. GDP equals $11,800 billion ($8,000 + 1,900 + 2,200 - 300).

8 GDP equals consumption spending plus government spending on goods and services plus investment spending plus net exports.

2. Real GDP increased by 7 percent. If nominal GDP has increased by 8 percent and prices have increased by 1 percent, than real GDP has increased by the difference – 7 percent.

3. Price must have decreased by 4 percent, in this case an instance of deflation. If nominal GDP decreases by 1 percent while the amount of output increases by 3 percent, then prices must have decreased by 4 percent. (This instance is an unusual combination of deflation and rise in output.)

Other Questions for Students

1. If gross domestic product increases by 1 percent over a year, are we better off? Why or why not?

2. If consumers begin to purchase automobiles manufactured in the U.S. instead of those manufactured abroad, what will happen to real GDP? Will the answer be different if consumers are simply increasing their spending and not reducing their spending abroad?

3. Why are wages and profits not included in gross domestic product?

Sample Answers for Additional Questions

1. Perhaps we are better off, but it is unlikely. Part of the answer depends upon what is happening to prices and what is happening to population. If prices and population together are rising by more than 1 percent per year, than we, on average, are worse off. We have fewer goods and services per person. It is highly likely that at any one time prices are rising more rapidly than 1 percent (an annual rate of 1.6 percent in this announcement) and that population is rising by about 1 percent per year.

2. Consumption spending will remain the same; however, imports will decrease. Real GDP in the U.S. will increase as production increases. In the second instance, consumption spending increased, but imports do not change. Real GDP does change, as consumption rises.

3. Gross domestic product includes all of the production of goods and services in a year. Production of consumption, investment, government, and net export goods is included. Therefore, wages are not added to the total amounts of production when calculating GDP. But, production also generates income. Every dollar that is spent on goods and services eventually becomes income to someone - the workers, the

9 owners, and the lenders. An alternative way of calculating GDP is to add all of the incomes earned by all participants in the economy.

Key Concepts

Consumption Investment Government expenditures Net exports Real GDP and nominal GDP Real GDP per capita Productivity Economic growth

Relevant National Economic Standards

The relevant national economic standards are numbers 15, 18, 19, and 20.

15. Investment in factories, machinery, new technology and in the health, education, and training of people can raise future standards of living. Students will be able to use this knowledge to predict the consequences of investment decisions made by individuals, businesses, and governments.

18. A nation's overall levels of income, employment, and prices are determined by the interaction of spending and production decisions made by all households, firms, government agencies, and others in the economy. Students will be able to use this knowledge to interpret media reports about current economic conditions and explain how these conditions can influence decisions made by consumers, producers, and government policy makers.

19. Unemployment imposes costs on individuals and nations. Unexpected inflation imposes costs on many people and benefits some others because it arbitrarily redistributes purchasing power. Inflation can reduce the rate of growth of national living standards because individuals and organizations use resources to protect themselves against the uncertainty of future prices. Students will be able to use this knowledge to make informed decisions by anticipating the consequences of inflation and unemployment.

20. Federal government budgetary policy and the Federal Reserve System's monetary policy influence the overall levels of employment, output, and prices. Students will be able to use this knowledge to

10 anticipate the impact of federal government and Federal Reserve System macroeconomic policy decisions on themselves and others.

Original U.S. Bureau of Economic Analysis Announcement and Data:

http://www.bea.doc.gov/bea/newsrel/gdpnewsrelease.htm

Sources of Additional Activities

Advanced Placement Economics: Macroeconomics. (National Council on Economic Education)

Unit 2: Measuring Economic Performance

Focus on Economics: High School Economics (National Council on Economic Education)

Lesson 18. Economics Ups and Downs

Economics USA: A Resource Guide for Teachers

Lesson 6: U.S. Economic Growth: What Is the Gross National Product?

Capstone: The Nation’s High School Economics Course

Unit 5: 2. What Do We Want from Our Economy? Unit 5: 3. An Economy Never Sleeps Unit 6: 2. Making a Macro Model: Consumers Unit 6: 3. Making a Macro Model: Investment Unit 6: 4. Making a Macro Model: Government Unit 6: 5. Making a Macro Model: Imports and Exports

Handbook of Economic Lessons (California Council on Economic Education)

Lesson 6: Measuring How Our Economy is Doing Lesson 7: Measuring How Our Economy Is Doing: GNP Lesson 20: Plotting the Ups and Downs of the U.S. Economy Lesson 21: The Fluctuating Economy: A Look at Business Cycles

Learning from the Market: Integrating the Stock Market Across the Curriculum

Lesson 23. Business Cycles and Investment Choices

Geography: Focus on Economics

11 Lesson 4. International Interdependence Lesson 7. Places and Production Lesson 8. GDP and Life Expectancy

All are available in Virtual Economics, An Interactive Center for Economic Education (National Council on Economic Education) or directly through the National Council on Economic Education.

Author: Stephen Buckles Vanderbilt University