Question

1. How 'fast' can the economy grow? That is, what is its potential growth rate? What two factors determine the potential growth rate? How does the potential growth rate of the economy impact Federal Reserve policy?

Answer 1

Potential growth rate of the economy is determined by the growth in the real Gross Domestic Product of a nation. Potential growth rate refers to the increase in the value of goods and services produced in an economy. The factors that determine the potential growth rate of an economy can be categorized in the following two heads:

a. Demand Side factors - Changes in consumer expenditure, investment expenditure by the firms, government spending or net exports of the nation can lead to changes in aggregate demand and also change the potential growth rate of the economy.

b. Supply Side factors: The supply side factors that can lead to changes in potential growth rate of the economy include - quality of the human resource of the nation, changes in the quantity of natural resources available in the economy, capital formation including land, building, machinery, power, transportation etc.Technological development in the nation also determines the potential growth rate of the economy.

The potential growth rate of an economy impact the Federal reserve policy of the nation. if the potential growth rate in the economy is high and economy is operating above the potential level of output, then to reduce inflation rate in the economy, Fed will have to reduce the level of money supplied in the economy to increase increase rates and thus reduce investment expenditure in the economy. On the other hand if the economy is operating below the potential level of output, then Fed will increase the level of money supplied to reduce interest rate in the economy and thus increase investment expenditure which will increase aggregate demand and thus move the economy to its potential level.