Gross Domestic Product(Measure of Economic Activity)

Web: www.bea.doc.govMonthly revisions, annual revisions in July, benchmark changes every 5 years.

Gross domestic product (GDP) total value of all final goods and services produced in the U.S.

Most important economic indicator, can identify economic strengths and weaknesses. It is used by forecasters to project future economic activity, by business leaders for business planning and sales forecasting, by money managers for investment strategies, and policymakers to alter macroeconomic policies.

GDP = final sales + Inventory

Self-Sustaining Economic Expansion: Economic growth => employment => HH income => HH consumption => production => employment => HH income => self-generating growth cycleCycle can be interrupted by an outside shock (war, oil embargo,... )

Nominal GDP values output in current dollars (PY)Real GDP describes output in constant dollars (chain weighted)

Y = C + I + G + X – MIncrease in Y leads to higher living standards.Increase in P leads to lower living standards.

PY) = PY1 + YP1 + PY PY) = PY1 + YP1 + PY P1Y1 P1Y1 P1Y1 P1Y1

PY) = P + Y + 0 if P and Y are small P1Y1 P1 Y1

Y = PY) – P Y1 P1Y1 P1

--------------------------------------------------------------------------------------------------------------------------Market Analysis:Bonds: Compare GDP data to market expectations.If Y/Y < expectations => P/P => DBonds => iBonds

Stocks: If Y/Y > expectations => future corporate sales => future profits => PStocks

Dollar: If Y/Y > expectations => future corporate sales and interest rates => demand for U.S. stocks and bonds => Demand for dollars => dollar appreciates.

2

Quarterly % Change in U.S. Economic Output(Real GDP - Chainweighted 2005$)

2.7%2.6%3.0%

3.3%

4.2%

3.2%

2.1%

5.1%

1.6%

0.1%

2.7%

0.5%

3.6%

3.0%

1.7%

-1.8%

1.3%

-3.7%

-8.9%

-6.7%

-0.7%

1.7%

3.8%3.9%3.8%

2.5%2.3%

0.4%

1.3%1.8%

2.8%2.5%2.5%2.5%2.5%

3.5%3.5%3.5%3.5%

1.8%

-10%

-9%

-8%

-7%

-6%

-5%

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

04:1 05:1 06:1 07:1 08:1 09:1 10:1 11:01 12:01 13:01

Source: Department of Commerce.

Maximum Sustainable Growth Rate = 3%

Falling Potential Growth Rate•3.5% to 2.5%•Less investment spending•Lower leverage in post-credit era•Suppressed demand•Negative demographic trends•Lower total factory productivity growth

Recession Factors:•Loose monetary policy•Poor regulation•Lax bank supervision•Opaque derivatives•Shadow banking system•Lax investor diligence•Poor governance•Misaligned incentives•fraud

Below trend growth•Falling stimulus spending•Less inventory rebuilding•Slowing Euro-Zone•Financial crisis•Deleveraging households•Rising savings rates

Components of GDPPERSONAL CONSUMPTION EXPENDITURES, OR “CONSUMPTION”

Consumption Spending by households on goods and services, not including spending on new houses.

GROSS PRIVATE DOMESTIC INVESTMENT, OR “INVESTMENT”

Investment Spending by firms on new factories, office buildings, machinery, and inventories, and spending by households on new houses.

GOVERNMENT CONSUMPTION AND GROSS INVESTMENT, OR “GOVERNMENT PURCHASES”

Government purchases Spending by federal, state, and local governments on goods and services.

NET EXPORTS OF GOODS AND SERVICES, OR “NET EXPORTS”

Net exports Exports minus imports.

Spending = C + I + G + X – M % of total = (70.7) (13.5) (18.8) (13.3) (-16.4) Growth rate = (2.0) (20.0) (-4.6) (4.7) (4.4)Contribution = (1.5) + (2.4) + (-0.9) + (0.6) + (-0.8) = 2.8%

(1+0.028)1/4 -1 = 0.007 = 0.7%

4th Quarter 2011 GDP

Annual % Change in U.S. Economic Output(Real GDP - Chainweighted 2005$)

3.1%2.9%

3.8%

3.4%

1.8%

3.1%2.9%

4.1%

2.5%

3.7%

4.5%4.4%

4.8%

4.1%

1.1%

1.8%

2.5%

3.5%

3.1%

2.7%

1.9%

-0.3%

-3.5%

3.0%

1.7%

-0.5%

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

Source: Department of Commerce.

Domestic Production, Y =100

Sales, C + I + G + X 71 + 13 +20 +14

Inventory

Foreign Production, M=18

Equilibrium Condition

Q.S. = Q.D.

Y + M = C + I + G + X

2011 $ Trillion

$15.1 + $2.7 = $10.7 + $1.9 + $3.0 + $2.1

Divide by Y (15.1 trillion) to get relative perspective

100% + 18% = 71% + 13% + 20% + 14%

For heuristic reasons, multiply by 100

100 + 18 = 71 + 13 + 20 + 14Or

100 = 71 + 13 + 20 + 14 – 18

Y = C + I + G + X - M

The Circular Flow Diagram$15.1 Trillion

$1.9

$3.0

$2.1

$2.7

$0.6

$10.7-2.7= $8.0

Resource Cost-Income ApproachExpenditure Approach

The two methods of calculating GDP are summarized below:

Personal consumption expenditures

+ Gross private domestic investment

+

Government consumptionand gross investment

+Net exports of goods and services

Aggregate income:Employee CompensationIncome of self-employedRents Profits Interest

+Non-income cost items:

Indirect business taxesand depreciation

Net income of foreigners+= GDP

Two Ways of Measuring GDP:

= GDP

The Expenditure Method of Measuring GDP

Expenditure Approach:GDP is the sum of expenditures on final-user goods and services

purchased by households, investors, governments, and foreigners.

There are four components of GDP: • personal consumption purchases • gross private investment

(including inventories) • government purchases

(consumption and investment)• net exports (exports minus imports)

Resource Cost-Income Method of Measuring GDPResource Cost - Income Approach

GDP is the sum of costs incurred and income (including profits) generated by the production of goods and services during the period.

The direct cost income components of GDP:employee compensationself-employment income rents interestcorporate profits

Sum of these = national income

Not all cost components of GDP result in an income payment to a resource supplier. To get GDP, we need to account for 3 other factors:

Indirect business taxes: Taxes that increase the firm’s production costs and therefore final prices.

Depreciation: The cost of wear and tear on the machines and other capital assets used to produce goods and services.

Net Income of Foreigners: The income that foreigners earn producing goods within the borders of the U.S. minus the income Americans earn abroad.

Real GDP versus Nominal GDP

Calculating Real GDP

Real GDP The value of final goods and services evaluated at base year prices.

Nominal GDP The value of final goods and services evaluated at current year prices.

The GDP DeflatorPrice level A measure of the average prices of goods and services in the economy.

GDP deflator A measure of the price level, calculated by dividing nominal GDP by real GDP, and multiplying by 100.

100 x GDP Real

GDP Nominal deflator GDP

Other Measures of Total Production and Total Income

Gross Domestic Product (GDP) $14.242 Trillion+ Foreign production of domestic firms $0.591 Trillion

- Domestic production of foreign firms $0.470 Trillion

Gross National Product (GNP) $14.364 Trillion- Consumption of fixed capital (depreciation) $1.851 Trillion

Net National Product (NNP) $12.513 Trillion- Indirect business taxes (sales tax) $0.163 Trillion

National Income $12.350 Trillion- Retained earnings $1.359 Trillion

+ Transfer payments & government bond interest $1.093 Trillion

Personal Income $12.084 Trillion- Personal tax payments (federal personal income tax) $1.086 Trillion

Disposable Personal Income $10.998 Trillion- Personal outlays $10.503 Trillion

Personal Savings $0.495 Trillion

Business Inventories(Measures Total Business Inventories and Sales)

Web: www.census.govSmall monthly revisions, with annual benchmark changes every spring.

Business inventories – amount of goods manufacturers, wholesalers and retailers keep in stockrooms. Changes in retail inventories gives 1st indication of a changing economy.

Corporate managers must decide the optimal level of inventories based on present orders/sales and expected future demand. Must keep enough goods on hand to make sales.

Inventories are typically financed with short-term loans. So a drop in sales => increase in inventories => financial stress.

Excess inventories can lead to recessions (Domino Effect) retail sales => retail inventories => wholesale orders => wholesale inventories => factory orders => factory production => layoffs => HH

income => HH consumption => retail sales => self-reinforcing downward spiral (recession),…. But process eventually corrects itself => Retailers employ discounts/sales/incentives => retail sales =>inventory =>orders across pipeline to replenish stock rooms => economic activity

Improvements in technology and software => “just in time” inventory management systems => reduction in large inventory swings => more stable economy

Total Business Sales - includes manufactures, wholesalers and retailers’ sales numbers.

Inventory-to-Sales (I/S) Ratio – number of months needed to sell inventory based on latest monthly sales rate.Typically a lagging economic indicator (tends to follow overall pace of economy). But can be a leading indicator of future orders and production

activity.Firms must determine optimal I/S ratio. Need inventory to make sales. General rule of thumb for I/S is 1.5 months, but depends on industry. Auto

industry is 2 months.Use Total Retail I/S ratio (excluding motor vehicle and parts components) to reduce large data fluctuations.If I/S > 1.5 => orders => slowing economyIf not in recession and I/S < 1.5 => S/S > I/I => factory orders => retail inventories => accelerating economy

Recall GDP = final sales + Inventory. So inventory changes play major role in economic growth calculation. Inventory component of economic growth:Real % Inventory GDP = (3-month % Total Inventories) – (3-month % Producer Price Index)

--------------------------------------------------------------------------------------------------------------------------Market Analysis:

Bonds: If I/I > S/S => I/S => orders => Y/Y => P/P => DBonds => iBonds

Stocks: If I/S > 1.5 => orders => slowing economy=> future profits => PStocks

Dollar: If I/S > 1.5 => orders => slowing economy and lower interest rates => demand for U.S. stocks and bonds => Demand for dollars => dollar depreciates.

Inventory-to-Sales Ratios

1

1.1

1.2

1.3

1.4

1.5

1.6

1.7

1.8

92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

1

1.1

1.2

1.3

1.4

1.5

1.6

1.7

1.8

Recession Retail I/S Total I/S Ratio

Wholesale I/S Manufacturers I/S