GDP Growth: What’s the Ideal GDP Growth Rate?

Gross domestic product (GDP) is one of the key economic indicators used to measure the economy and track its progress. Often, people equate a high GDP with economic prosperity and a low GDP with a failing economy. However, this isn’t always so. The correlation is not as simple as high is good and low is bad.

Positive Growth vs. Negative Growth

GDP growth rate indicates the percentage increase from quarter to quarter or from year to year. It indicates how the economy is growing compared to the previous quarter or year. Negative growth means the economy produced less than the previous period. This isn’t a good thing as it can signal a recession. Two consecutive quarters of negative GDP growth is defined as a recession, and an extended period of negative growth turns into economic depression.

On the other hand, positive growth is considered generally good. It is an indication that the economy is in healthy shape and the nation is progressing. It implies that there is an increase in money supply and economic output and productivity are improving.

What is the ideal GDP growth rate?

The ideal GDP growth rate depends on the country and its economic expansion cycle. In China and India, a rate of 2% to 3% is considered poor. However, this rate is considered healthy in the United States. The US targets 2% in real GDP growth so the economy stays in the expansion phase as long as possible. Real GDP growth is used to set ideal rates because it adjusts for inflation. This is in contrast with nominal GDP growth, which accounts for the price changes in the current market.

Whatever the growth rate is, it should be balanced with unemployment and inflation. A healthy economy is characterized by strong GDP growth, natural unemployment rate, and low to manageable inflation. Ideally, an increase in GDP lowers the unemployment rate due to higher demand for goods and services. However, an unemployment rate that falls below 4% is an indication that businesses can’t hire enough workers. This could hinder them from operating at full capacity and eventually lead to slower economic growth and higher inflation rate. As such, a delicate balance must be maintained among these three factors.

Is a high GDP good?

High GDP isn’t necessarily good and can cause problems just like low GDP. If GDP surges too high, it can cause overheating of the economy and potentially create asset bubbles that could lead to big falls in the future. Eventually, bubbles pop and result in inflation.

One concrete example of this is the Y2K scare in the late 1990s that created a bubble in internet investments but ultimately caused the 2001 recession. Stock prices of tech companies also surged as investors bought as many stocks in tech companies as they could. From 1995 to 1999, the GDP steadily increased from 2.7, 3.8, 4.4, 4.5 to 4.8. Looking at the quarterly GDPs, you’d see that it reached a high of 7.5 in the 2nd quarter of 2000. However, by the 1st quarter of 2001, GDP had fallen to an abysmal -1.1, leading to a recession.

There are also other scenarios where high GDP isn’t a good thing such as when it rises due to increased purchases of goods and services after a natural calamity or disaster. GDP may have increased but it might not be economically beneficial for those who had to recover from injuries, rebuild homes, or replace lost properties.

Another example is an exponential GDP growth due to increased sales of products that are detrimental long-term such as tobacco. GDP may be higher but it could put people’s health at potential risk down the line.

Managing GDP Growth

The Federal Reserve plays a big part in managing GDP based on interest rates and the cost of borrowing money. If the GDP is too high, they raise interest rates and vice-versa. They have the onerous task of keeping the economy in the ideal zone using appropriate monetary policies.

After the surge in GDP due to the Y2K scare, the economy fell into recession. Stock prices declined, and many small tech companies went bankrupt. To help end the 2001 recession, the Federal Reserve implemented an expansionary monetary policy that started lowering rates in January 2001. Rates were lowered about half a point every month that by December that year, the rate was a mere 1.75%. The lower interest rates made homes, education, and auto purchases more affordable. This also enabled businesses to borrow more and expand faster, contributing to better economic growth.

Another instance when the Fed took drastic action was in the Great Inflation of the 1970s. From 1976 to 1978, GDP had soared to 5.4%, 4.6%, and 5.5% after a recession in the previous years. However, prices were rising fast and inflation was at double digits. To stop rampant inflation, the Fed raised rates to 20%.

This particular decade also illustrates how economic policies that affect GDP growth are influenced by political leaders and governments. In 1969, Nixon inherited a recession from the previous administration and his first few years as president saw weak economic growth. In 1971, he imposed low interest rates and wage-price controls that made the economy seem strong in time for re-election. In 1973, he ended the gold standard that eventually created inflation. These and other macroeconomic policies resulted to stagflation where economic growth was weak and both unemployment and inflation were high.

GDP Doesn’t Measure Everything

While positive growth in GDP indicates a healthy economy, it isn’t always a good indicator of the general well-being of people. It doesn’t reflect living conditions such as the state of the environment or people’s health. It also doesn’t factor how wealth is distributed. Ultimately, overall fiscal policy and whether GDP growth is genuinely helping all citizens is probably what matters more.

See the full stats on GDP by president here.