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A CASE STUDY
Gross Domestic Product
First Quarter, 2005
Date of Announcement
April 28, 2005
Date of Next Announcement
May 26, 2005
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.
Interactive question.
Higher
Is this rate of change higher or lower or the
same relative to the last quarter and last year?
Lower
No change
Answer.
(This should pop up.)
Lower
This increase is lower than the last quarter and the last year. The annual growth rate
for the last quarter of 2004 was 3.8 percent. During 2004, real GDP increased by 4.4
percent.
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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.
Goals of Case Study
The goals of the GDP Case Studies are to provide teachers and students:
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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 3.1 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
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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?
Prices:
Increased by
3.3 percent
Pop-up answer-
Decreased by
3.3 percent
Increased by
9.5 percent
Increased by
3.3 percent
Correct answer. The reasoning is that while GDP increased by 6.4 percent percent, real
GDP increased by 3.1 percent. The difference is due to price increases.
One way to approximate the change is to subtract 3.1 percent from 6.4 percent. This
gives the answer above of 3.3 percent. The actual change was 3.2 percent. The
difference is due to rounding.
For math classes and more advanced students, the more exact method of calculation
is to divide 1.063 by 1.031. Still due to rounding the result differs slightly from the
actual 3.2 percent increase in prices.
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.
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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
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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
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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. (See the most recent Productivity case study).
Productivity, defined as the amount of output per hour of work, increased at an annual
rate of 2.6% 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
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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.
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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.
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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.
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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.
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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.
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.
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Country
China
Hong Kong
United Kingdom
Population
1,288,000,000
6,800,000
59,300,000
GDP in billions
$1,417 billion
$176 billion
$1,680 billion
Per capita GDP
$1,100
$25,860
$28,320
2003 GDP in billions of current US dollars
(International Monetary Fund, World Bank)
Teachers. A copy of this table is available in the PowerPoint attachment.
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.
(The comparisons in the above table are of GDP per capita, not real GDP per capita.
As we are comparing per capita figures for the same year there is no need to deflate the
figures into real figures.)
ARE ESTIMATES OF GDP ACCURATE MEASURES OF OUR WELL BEING?
Write out your answer.
GDP fails to account for many forms of production that improve a
person’s well being. For example, if you family makes 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 producers begin to
employ production techniques that create more pollution, the effects of the
economic growth are overstated.
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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.
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.)
Interactive questions for students.
1. Given the following data (in billions of current dollars) a.
What is the level of investment in the calculation of GDP?
b.
What is the level of net exports?
c. What is the level of government spending?
d.
Calculate the level of Gross Domestic Product.
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Consumption spending
Wages
Social security payments
State and local spending on
goods and services
Income tax receipts
Construction of new homes
Changes in inventories
Exports
Business purchases of new factories
and equipment
Federal government spending on
goods and services
Imports
$ 10,000
11,000
500
1,500
2,000
500
- 200
2,000
2,000
1,000
1,500
2. If GDP has increased by 6 percent and inflation is 2 percent, what has happened to
real GDP?
3. If GDP increases by 4 percent and real GDP increases by 3 percent, what has
happened to the average price level?
Answers to interactive questions.
1. Investment equals $2,300 ($2,000 + 500 - 200).
New factories and equipment and construction of new homes are included in
investment. However, since business inventories fell, we subtract $200 billion
from investment in structures, equipment, and residential housing to get the
investment portion of GDP.
Net exports equal $500 ($2,000 - 1,500).
Net exports are exports minus imports. In this case, the economy has a balance
of trade surplus. That is more exports than imports.
Government spending equals $2,500 ($1,000 plus $1,500).
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.
GDP equals $15,300 billion ($10,000 + 2,300 + 2,500 + 500).
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GDP equals consumption spending plus government spending on goods and
services plus investment spending plus net exports.
2. Real GDP increased by 4 percent. If nominal GDP has increased by 6 percent
and prices have increased by 2 percent, than real GDP has increased by the
difference – 4 percent.
3. Prices must have increased by 1 percent. If nominal GDP increases by 4
percent while the amount of output increases by 3 percent, then prices must have
increased by 1 percent.
Other Questions for Students
1. If gross domestic product increases by 5 percent in 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 income taxes and social security payments not included in gross domestic
product?
Sample Answers for Additional Questions
1. Perhaps we are better off. 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 5 percent per year, than we, on average, are worse off. We have
fewer goods and services per person. But if prices are increasing at about 3 percent
per year and population is growing at about 1 percent per year, then real GDP per
capita is increasing at about 1 percent a year.
2. Consumption spending will remain the same; however, imports will decrease. Real
GDP in the U.S. will increase as production increases and the calculation of real
GDP shows an increase by the amount of the decrease in imports. In the second
instance, consumption spending increased, but imports do not change. Real GDP
does change, as consumption rises. In both cases, GDP in the U.S. increases.
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. Taxes and social security payments are not production of goods and
services and therefore are not included. However, they may influence gross domestic
product. If income tax rates increase, individuals may reduce their consumption
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spending and production may fall. If social security payments to recipients increase,
some individuals will have more income and increase their consumption spending.
Production of consumption goods may increase as a result.
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
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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.gov/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.
Unit 5: 3.
Unit 6: 2.
Unit 6: 3.
Unit 6: 4.
Unit 6: 5.
What Do We Want from Our Economy?
An Economy Never Sleeps
Making a Macro Model: Consumers
Making a Macro Model: Investment
Making a Macro Model: Government
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
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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
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