# The Effect of Real GDP on Interest Rate

stock market analysis screenshot image by .shock from Fotolia.com
Share It

Being a small business owner is about more than strategically chasing your dreams, mission and vision. It is also about understanding how much your success is intertwined with the health of the overall economy.

As a business leader, it is wise to become knowledgeable about the relationship between interest rates and the GDP. This can help you prepare your business for good times and bad, with more confidence about weathering economic storms and ensuring job security for you and your treasured employees.

## What Is GDP?

Gross domestic product, also known as GDP, is a measure that shows the value of all the services and goods produced by a country in a particular calendar year. Nominal GDP calculates this output based on current market prices. This equation is typically used to calculate nominal GDP: GDP = C + G + I + NX.

• C = Consumer spending
• G = Government spending
• I = Business capital spending
• NX = Net exports

## Inflation and Real GDP

While nominal GDP makes calculations based on current market prices, real GDP takes inflation into account. This means that real GDP provides a more accurate reflection of economic growth or decline than nominal GDP alone. The real GDP formula that more accurately reflects economic growth or decline is as follows: Real GDP = Nominal GDP / Deflator.

In a fictional scenario, this means that if the nominal GDP is \$250 million and the interest rate is 2%, you would calculate real GDP this way:

• 250 million / 1.02 = 245.01 million

In this scenario, factoring inflation into the equation would show that the economy actually created \$245.01 million in services and goods rather than the \$250 million suggested by nominal GDP.

## Understanding Interest Rates

Interest rates are fees charged by lenders for use of their capital. This rate is often given as an annual percentage rate, or APR. Interest rates are how lenders make money by charging you to use their assets. A business or individual with good credit is typically seen as low risk and is charged a lower interest rate than those with questionable credit histories.

While interest rates are determined by lenders, they are influenced by what is happening in the overall economy. For instance, in the United States, the Federal Reserve will raise or lower the federal funds rate in order to facilitate higher or lower interest rates to be passed on to the consumer. Someone with good credit will have a higher interest rate when the federal funds rate is high than when it is low.

## Real GDP and Interest Rates

Real GDP is part of how the Federal Reserve determines when to raise and lower the federal funds rate. For instance, if inflation is high and nominal GDP is down, then the real GDP will fall substantially. In order to get more money circulating in the economy, the Fed will lower the federal funds rate, which results in lower interest rates for businesses and consumers, prompting a higher velocity of lending and thus injecting more money into the economy — and hopefully raising the real GDP down the road.

When inflation is low and nominal GDP is up, then real GDP increases, signaling plenty of money circulating in the economy. If the Federal Reserve needs to slow down a burst of financial activity, it might raise the federal funds rate, resulting in higher interest rates for you and your customers.

## Planning for the Future

Small business owners can keep track of what is happening with nominal GDP, real GDP, the federal funds rate and interest rates in order to plan for a healthy financial future. It's wise to have a financial cushion for your business to help you through down economic times. You might also design a few products or services that will appeal to consumers and meet a need even when the economy is slow.