Benjamin Montgomery

Question: Are Interest Rates Directly Proportional To GDP Growth?

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Since the politicians and pundits feel that the interest rate is the key to the entire economy what does the interest rate really tell us?

I am going to argue that in a free (not manipulated) market the average interest rate actually should relate directly to the projected GDP growth.  Not inversely as many politicians assume.

Basically the interest rate is telling us that if you give me X amount of capital today one year from now I will be able to produce at least X+”interest rate” of capital to pay you back the principle plus the interest.   On average people only would lend and borrow what they could pay back through added production.  Thus, the interest rate is directly proportional to the GDP growth.

This means that higher interest rates in a free market actually mean that GDP growth should be greater.

Well, that was in a free market and we all know that interest rates operate in anything but a free market.  The Federal Reserve gets to set the interest rates and print the money to enforce them, so they can raise and lower it on a whim.

The dogma for many years has been that you need to lower interest rates to stimulate GDP.  However, if the above is true and interest rates are directly proportional to GDP wouldn’t lower interest rates lead to lower GDP growth?

When thinking about broad economic policy it is always best to take it to the smallest scale possible, the individual, to see if it makes sense.

If some one gave you $100 dollars and said in a year you only have to pay me $101 dollars how much would you produce?  Personally, I would produce $1 because that is all that I needed to pay back what I owe.   Now if some one loaned me $100 and in a year I had to pay back $115 dollars I would now have to produce $14 more dollars then before.

In which case was there more production?

Seems to me that higher interest rates are not something to be scared of.  It just means that we are producing more and growing the GDP.

Please let me know your thoughts.  But before a knee jerk reaction consider the possibility that interest rates are in fact directly proportional to GDP growth.

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Written by benmont1981

October 21, 2008 at 8:00 am

Posted in Uncategorized

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