Now that we understand how GDP is computedÂ and its components we need to research the historic GDP growth rates in the country of interest. What were the levels of stocks, bonds and foreign currency during that period of growth? We also need to look at inflation and interest rate levels in each of those phases. We begin by looking at historical growth trends in the US economy, how growth rates are calculated and the difference between real and nominal growth.
US Historical Growth Rates
Now we look the historic growth rates in the US economy and why central banks and policy makers strive to contain growth within a sustainable level.
The growth rate an economy will experience can fall into three phasesâ€”high growth, sustainable growth and recession. It is important to understand the historic context of growth in that particular economy in order to classify growth under these three categories. A high growth of say 6-7% in a highly developed economy such as the US might not be sustainable unless the economy is just moving out of recession but it can be the average growth rate in an emerging economy such as India or China. The general consensus is that real growth between 2.5%-3.5% in the US economy is sustainable without inciting inflationary concerns.
In countries such as the US, during high growth periods when the economy is expanding at 6-7%, the demand for goods and services is rapid and puts an upward pressure on prices. Price increases overtake wage increases, dampening consumer spending. Consumers start spending on borrowed money thereby increasing debt expansion. High inflation and increased debt spending causes the Federal Reserve Bank to react by increasing interest rates to cool the economy. An increase in interest rates increases borrowing costs for firms thereby reducing debt expansion and business investments and slowing down the economy.
The reverse happens during a recession. A recession is defined as two consecutive quarters when the real GDP is negative. In this scenario, the central bank reduces interest rates to boost spending. A lower cost of borrowing for consumers and firms induces spending and investment. It is usually seen that when the real GDP moves above or below a sustainable growth rate the central bank uses its monetary tools to increase or lower short term interest rates to bring growth back to a sustainable level.
Figure: GDP Annual Average Nominal Growth Rate, 2005-2015
Next let us understand how growth rates are computed