1. How ‘fast’ can the economy
1. How ‘fast’ can the economy grow? That is, what is itspotential growth rate? What two factors determine the potentialgrowth rate? How does the potential growth rate of the economyimpact Federal Reserve policy?
Answer:
Potential growth rate of the economy is determined by the growthin the real Gross Domestic Product of a nation. Potential growthrate refers to the increase in the value of goods and servicesproduced in an economy. The factors that determine the potentialgrowth rate of an economy can be categorized in the following twoheads:
a. Demand Side factors – Changes in consumer expenditure,investment expenditure by the firms, government spending or netexports of the nation can lead to changes in aggregate demand andalso change the potential growth rate of the economy.
b. Supply Side factors: The supply side factors that can lead tochanges in potential growth rate of the economy include – qualityof the human resource of the nation, changes in the quantity ofnatural resources available in the economy, capital formationincluding land, building, machinery, power, transportationetc.Technological development in the nation also determines thepotential growth rate of the economy.
The potential growth rate of an economy impact the Federalreserve policy of the nation. if the potential growth rate in theeconomy is high and economy is operating above the potential levelof output, then to reduce inflation rate in the economy, Fed willhave to reduce the level of money supplied in the economy toincrease increase rates and thus reduce investment expenditure inthe economy. On the other hand if the economy is operating belowthe potential level of output, then Fed will increase the level ofmoney supplied to reduce interest rate in the economy and thusincrease investment expenditure which will increase aggregatedemand and thus move the economy to its potential level.
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