The economic growth rate is used to measure the growth of an economy, usually in terms of its output or gross domestic product (GDP). GDP measures the value of all goods and services produced by an economy over a certain period of time.
Understanding Economic Growth Rate
Nowadays, market-based economies revolve around continuous growth. An economy is defined as a set of inter-related activities for production and consumption that determines how limited resources are allocated. Market-based economies distribute these scarce resources with a market system, wherein the economic forces of supply and demand determine the allocation of resources.
A market-based economy prospers by being able to produce more goods and services over time, which in turn leads to more tangible wealth in the form of money, and in theory, every participant in the market economy is better off.
Gross Domestic Product (GDP) is a very important measure in economics that is used to gauge the health of an economy. GDP is measured for individual economies. For example, each country can measure its GDP on a quarterly or annual basis. By measuring GDP over time, the growth rate of GDP can be determined.
Governments, economists, businesses, and investors monitor economic indicators, such as GDP growth, very closely in order to understand where the economy currently stands, and where the economy is headed in the future.
For a developed economy, an annual GDP growth rate of 2%-3% is considered normal. Therefore, any GDP growth above the said rate is a strong sign that an economy is expanding and prospering.
A prospering economy creates more wealth, which leads to increased spending. Businesses generate more revenues, resulting in the hiring of more workers who end up spending more in a virtuous cycle. In contrast, if GDP growth is below 2% or is negative, it can indicate that an economy is entering into a recession.
A recession is when GDP declines for consecutive periods. A recession is usually bad for market economies since it is a sign that there is less wealth, which leads to less spending as people are more conscious of saving money. The decline in spending, in turn, leads to reduced business earnings, and such businesses may lay off workers, who spend even less in a vicious cycle.
Understanding Economic Cycles
Market economies naturally go through cycles of either:
As mentioned earlier, it is in all market participants’ best interest for the economy to be growing/expanding. The growth leads to more wealth, more jobs, and more spending. However, it cannot continue indefinitely, since the heightened spending contributes to higher inflation.
Inflation occurs when there is excess money and not enough goods being produced. In simple terms, more dollars are chasing fewer goods. The prices of goods begin to increase, and the value of the money starts to decrease. If the inflationary pressure continues for prolonged periods of time, it can adversely affect the economy.
Therefore, when inflation becomes too high, the economy will naturally enter a recession in order to cool off the inflation. Over time, the level of inflation becomes manageable, and the economy re-enters a period of expansion again.
Economic Growth Rates in the World
As mentioned earlier, a developed economy such as the United States or Canada should expect a GDP growth rate of around 2%-3% on average. There are fewer opportunities for profitable projects, and the economy can only expand a marginal amount.
In other areas of the world, developing economies such as China and India expect high GDP growth rates. Both are growing at around a 6%-7% amount on average – almost triple that of a developed economy. It occurs because there are many opportunities for profitable projects since many areas of such highly populated countries are beginning to produce and demand more goods and services.
The growth leads to many investors taking advantage of the opportunities and investing their money in countries that offer higher potential for growth. From an investor’s perspective, such economies are more likely to provide excess returns for investments. However, the economies also come with heightened risks as well. Fast economic growth leads to pitfalls such as inflation, as mentioned earlier.
Inflation works against real returns. For example, if an investment with a 10% nominal yield in a developing country, but that country with a 7% inflation rate, the real return is only 3% (10% – 7%). It is an important consideration when making cross-border investments.
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