A country's gross domestic product, or GDP, is the value of the economic products produced in any given year, including all goods and services. A "real" GDP takes into account inflation, measuring the value of the goods and services using their prices from the previous year. A country's GDP and its interest rates are linked in a variety of ways.
The effect of real GDP on interests rates is essentially equivalent to the effect of domestic economic growth on interest rates, according to the economist Steven M. Suranovic. A rise in GDP, according to Suranovic, will lead to a rise in interest rates, as demands for funds increase.
There are several reasons that an increase in GDP can lead to a rise in interest rates. For one, when an economy is booming, more investors will be investing money in it. This increased demand for funds can lead to lenders asking for higher interest rates. Secondly, as an economy booms, inflation will generally increase. This will lead to an increase in the interest rate commanded by lenders, so as to keep pace with inflation.
A rise in GDP may also spark inflation that can outpace the growth of the GDP, putting the economy at risk of a meltdown. In order to cool an "overheated" economy, the U.S. Federal Reserve may raise the interest rate at which it lends out money. The higher interest rate at which borrowers from the Fed have to loan money often helps to put brakes on new investment. By contrast, the Fed may lower interest rates to coax new investment.
If increases in general interest rates are too rapid, it can depress the GDP badly, causing damage to the economy, according to the Economics Web Institute. This is because if credit is not available to businesses, new goods and products cannot be brought to market. The U.S. Federal Reserve must therefore be careful in how much it chooses to raise and lower interest rates.
Just as the GDP can affect interest rates, so can certain kinds of interest rates affect GDP. For example, when the U.S. Federal Reserve changes the rate at which it loans money, this has a number of effects on the economy. According to the Dallas Federal Reserve Bank, in the short tern, lower interest rates reduce the value of the dollar, which lowers the prices of the U.S.-produced goods sold for export. This leads to greater spending on U.S. goods and services, raising GDP.