**JOSHUA BRANT**
**College of Business**
**Western Carolina University**

**Abstract**

*This paper
describes a two-year forecast of U.S. Gross Domestic Product (GDP) from
2001 through 2002. The lagged GDP Deflator was chosen as the explanatory
variable to forecast future GDP. The forecast is based on the Quantity
Theory of Money equation of exchange. (The GDP forecast predicts a slight
downturn in GDP for the first half of 2001 followed by steady growth. The
forecast model shows a 1.6% drop in GDP for the first quarter of 2001 from
the last quarter of 2000 followed by subsequent growth starting at .06%
then gaining speed to 1.4% growth.) The U.S. government and the Fed need
to be concerned about a downturn in GDP, which could possibly turn into
a recession. If the Fed has some knowledge that a continued downturn in
GDP will occur, then it should take measures to counteract a possible recession.
(JEL: E17, E31)*

This paper
forecasts GDP for the years 2001 and 2002. The projection is based on the
Quantity Theory of Money. Gross Domestic Product is a measure of the total
production and consumption of goods and services in the U.S. GDP is a very
important indicator of economic activity and is therefore valuable to forecast.
The value of having a good forecast of GDP over the next two years will
enable businesses, investors, producers, and consumers a firm foundation
of expectation for making sensitive economic decisions now in preparation
for the future. The rest of this paper is organized as follows: part 2.
presents the data used to forecast GDP; part 3. explains the theoretical
basis for the approach adopted in forecasting GDP; part 4. presents the
forecast of GDP; part 5. evaluates the importance of the forecast for the
economy, and part 6. discusses conclusions for economic policy.

There are
two variables used to forecast. The forecast variable is GDP in billions
of chained 1996 dollars. The explanatory variable used is the GDP Deflator.
Both variables are taken from the Federal Reserve Bank of St. Louis’s Federal
Reserve Economic Data (FRED) database. Both variables are seasonally adjusted,
observed quarterly, and have a sample period from the fourth quarter of
1990 to the fourth quarter of 2000.

The forecast horizon is two years into
the future. The data is easily accessible and readily available. The data
chosen for the forecast is relevant as defined by the equation of exchange:
Where M is a measure of the money supply such as M1, M2, or M3, P is the price level, which may be measured by the real GDP deflator, Q is real GDP, and V is the income velocity of money.

**Part 3. Economic Theory**

The forecast assumes that inflation will remain at a near constant for the forecast period. Quarterly GDP will be calculated over the forecast period of two years. GDP Deflator data was taken from the fourth quarter of 1990 through the fourth quarter of 2000.

The Quantity Theory of Money is appropriate for forecasting GDP with the GDP Deflator because the equation of exchange shows that it will have direct relationship to GDP. Assuming that variables M and V are constant we can solve for Q as follows:

*MV/P = Q*

The forecasting equation used can be expressed as the function:

*Y _{t }= a+bX_{t-2}*

Where Y is forecast GDP and X is lagged GDP Deflator. Variables (a) and (b) are then substituted by the estimated intercept and coefficient values determined through regression analysis. We can now solve for Y as shown below.

*Y _{t} = -6980.48 +
155.6055(X_{t-2})*

**Part 4. GDP forecast for 2001
and 2002**

Explanatory Variable |
Estimated Coefficient |
t-ratio |

Intercept (a) |
-6980.48 |
-13.83 |

Coefficient (b) |
155.601 |
29.81 |

R Square = 0.9663 |
F (zero slopes) = 2.195 |
Probability (F) = .0839 |

Table 1 summarizes the regression that was run to forecast GDP. The intercept and X variable were used in the regression equation to forecast GDP. The R-squared is .966283, which means that approximately 97% of variation in GDP is explained by variation in GDP Deflator. The t-statistic for the intercept is equal to –13.82, and this indicates rejection of the null hypothesis that the intercept equals zero. The t-statistic for the coefficient on the GDP Deflator also rejects the null hypothesis but the F-statistic fails to do so.

The results
of this forecast are very interesting. The two-year forecast shows, for
the first four quarters, there will be a sharp decline in GDP followed
by a steady increase resembling current GDP figures. At the beginning of
the second year, GDP surges with substantial growth. The results of the
GDP forecast are shown in table 2.

Quarter |
Forecast |

2001.1 |
9247.618 |

2001.2 |
9303.636 |

2001.3 |
9340.981 |

2001.4 |
9395.443 |

2002.1 |
9529.264 |

2002.2 |
9627.295 |

2002.3 |
9692.649 |

2002.4 |
9778.232 |

The forecast predicts a possible recession for the year of 2001 due to decreases in GDP from the preceding year.

**Part 5. A Slow Start**

The forecast GDP starts low and with a slow growth pace but picks up nicely. If we are to have a recession for the year 2001, then the Federal Reserve will have to implement policies to counteract the recession. Some measures that the Federal Reserve may introduce in recessionary periods are to shift the aggregate demand curve to the right. The Federal Reserve must be concerned with a recession because it will have a negative effect on everyone in the economy.

**Part 6. Policy Conclusions**

It seems that GDP is expected to drop in the first quarter of 2001 by 1.6% and then climb slowly at a rate of .06%. GDP is expected to pick up the pace in the first quarter of 2002 with a forecast increase of 1.42%. Industries would be well advised to always have some liquidity to weather downturns in the economy. In this case it seems the downturn will be short and industries should be able to live through it passively.

The government in response to this forecast data can only respond with fiscal policy. A small tax cut designed to boost liquidity in the market would suffice here. The Federal Reserve would be more apt to respond with lowering interest rates and buying back T-Bills on the open market in order to increase liquidity.

**References**

Federal Reserve Bank of St. Louis, Federal Reserve Economic Data (FRED), http://www.stls.frb.org/fred/

Thomas, Lloyd B. Money, Banking, and Financial Markets. New York: McGraw-Hill Companies, Inc., 1997