Gross Domestic Product (Measure of Economic Activity) Web: Monthly 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 cycle Cycle 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 – M Increase in Y leads to higher living standards. Increase in P leads to lower living standards.  PY) =  PY 1 +  YP 1 +  P  Y P 1 Y 1 P 1 Y 1 P 1 Y 1 P 1 Y 1  PY) =  P +  Y + 0 if  P and  Y are small P 1 Y 1 P 1 Y 1  Y =  PY) –  P Y 1 P 1 Y 1 P Market Analysis: Bonds: Compare GDP data to market expectations. If  Y/Y   P/P =>  D Bonds =>  i Bonds Stocks: If  Y/Y > expectations =>  future corporate sales =>  future profits =>  P Stocks Dollar: If  Y/Y > expectations =>  future corporate sales and interest rates =>  demand for U.S. stocks and bonds =>  Demand for dollars => dollar appreciates.

2 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 GDP PERSONAL 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% ( ) 1/4 -1 = = 0.7% 4th Quarter 2011 GDP

Domestic Production, Y =100 Sales, C + I + G + X Inventory Foreign Production, M=18

Equilibrium Condition Q.S. = Q.D. Y + M = C + I + G + X 2011 $ Trillion $ $2.7 = $ $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 = Or 100 = – 18 Y = C + I + G + X - M

The Circular Flow Diagram $15.1 Trillion $1.9 $3.0 $2.1 $2.7 $0.6 $ = $8.0

Resource Cost-Income Approach Expenditure Approach The two methods of calculating GDP are summarized below: Personal consumption expenditures + Gross private domestic investment + Government consumption and gross investment + Net exports of goods and services Aggregate income: Employee Compensation Income of self-employed Rents Profits Interest + Non-income cost items: Indirect business taxes and 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 GDP Resource 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 compensation self-employment income rents interest corporate 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 Deflator Price 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.

Other Measures of Total Production and Total Income Gross Domestic Product (GDP) $ Trillion + Foreign production of domestic firms $0.591 Trillion - Domestic production of foreign firms $0.470 Trillion Gross National Product (GNP) $ Trillion - Consumption of fixed capital (depreciation) $1.851 Trillion Net National Product (NNP) $ Trillion - Indirect business taxes (sales tax) $0.163 Trillion National Income $ Trillion - Retained earnings $1.359 Trillion + Transfer payments & government bond interest $1.093 Trillion Personal Income $ Trillion - Personal tax payments (federal personal income tax) $1.086 Trillion Disposable Personal Income $ Trillion - Personal outlays $ Trillion Personal Savings $0.495 Trillion

Business Inventories (Measures Total Business Inventories and Sales) Web: Small 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 1 st 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 economy If not in recession and I/S  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 =>  D Bonds =>  i Bonds Stocks: If I/S > 1.5 =>  orders => slowing economy=>  future profits =>  P Stocks 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.