GDP and Interest Rates: Combining Concepts

You have read all about Gross Domestic Product and interest rates. But now you want to know why it matters, or at least how you can use them to make money, right?

We talked about how the interest rate can affect economic growth. A central bank can choose to increase interest rates, which decreases inflation but may slow economic growth. On the other hand, a central bank can decrease interest rates, which may boost inflation but also economic growth.

GDP and Interest Rates

You know that the central bank’s job is to guide the economy through good times and bad with interest rate policy. The central bank sets interest rates, which can have a direct effect on how much is produced in an economy.

This concept is best explained with an example. We’ll use an economy that produced $100 in goods and services last year (small numbers are easier).

Let’s say that the current rate of interest is 3%, GDP growth is 5%, and inflation is 1%. From those numbers we can extrapolate the following:

• Real rate of interest – The real rate of interest is the nominal rate minus inflation. Thus, we take 3% and subtract 1% to get 2%.
• Real GDP growth – Real GDP growth is the rate of growth minus the inflation rate. Therefore, we take 5% and subtract 1% to arrive at 4% in real GDP growth.

How Interest Affects Growth

Interest rates have a profound effect on real and nominal GDP growth. If a central bank were to increase the rate of interest to 5% from 3%, the growth in GDP would fall. Interest rates and GDP growth have an inverse relationship, where the GDP rises as interest rates fall, and vice versa.

In general, the rate of interest is set with an emphasis on keeping inflation at a predetermined level. The European Central Bank and the Federal Reserve both target 2% inflation rates. Some banks in emerging markets set an inflation rate of less than 6-7%. The ideal inflation rate should always be lower than GDP growth, so as the economy still creates real GDP growth when inflation is subtracted from nominal GDP numbers.

Forex traders should strive to learn these targets for every major currency they track. In a later lesson, we discuss the inflation targets for central bankers who represent the world’s largest economies.

Target Rates Matter

The target rate of inflation is very important to a currency value. Just as you learned traders can trade the news by betting that an economic report will or will not meet the “concensus” estimate, traders trade currencies based on the concensus for inflation.

If inflation rates rise higher than the target rate by central banks, the currency is rapidly sold off by investors who see the currency values falling in the future. If inflation comes in at less than expected while GDP growth remains roughly unchanged, the currency will grow in value as investors see it to be a safe place to store investment capital.