Effects of Potential GDP Growth Rate on Equity and Fixed Income

GDP is important because it controls inflation’s effects on an economy. If the real GDP growth is higher (lower) than the potential growth rate, the inflation rate will increase (decrease), affecting the nominal rates and bond prices.

Moreover, potential GDP determines the level of real interest rates and hence, the asset returns in the economy. If the potential GDP grows faster, consumers expect their income to rise. In other words, when the real interest rates rise, it increases capital accumulation savings. Therefore, a higher growth rate of the potential GDP means higher interest rates and expected asset returns.

More effects of potential GDP and its growth rate on equity and fixed income analysis are summarized below.

Impact of Potential GDP and Its Growth Rate on Equity and Fixed Income

1. When the potential GDP growth rate is high, fixed-income securities’ general credit quality tends to improve. The flow of income supports securities associated with fixed income, even if the lender owns some of the underlying assets.
2. The monetary policy decisions are based on resource usage and a flapping economy. Therefore, monetary decision policy is affected by the output gap (difference between the anticipated potential output and actual operating level) and actual GDP relative to the sustainable growth rate. Thus, fixed-income investors need to gauge the output gap and real and potential GDP growth rates to estimate the probability of a change in monetary policies.
3. The agencies responsible for credit rating utilize the potential GDP growth rate to assess the credit risk of external and government-issued debt. Therefore, slower growth of the potential GDP increases the credit risk.
4. During a recession, government budget deficits increase and decrease during expansion periods. Judging a fiscal policy concerns structural or doubtfully modified deficits according to a budgetary equilibrium in an economy running at a potential GDP.

Question

Over the past several years, a country’s stock market has appreciated substantially. Moreover, the corporate profits to GDP ratio have increased over the same period and surpassed the historical mean.

Based on this information, the corporate profits to GDP ratio of this country is most likely to:

1. Decrease from its present measure.
2. Increase from its present measure.
3. Remain near its present measure.

Solution

The correct answer is A.

This country’s corporate profits to GDP ratio has been rising over the years, but it will not do so forever. Simultaneously, the constant labor income would prompt the workers to halt their work unless the wages are increased. In turn, this will undercut the demand, making the profit margins unsustainable. Thus, it is probable that the corporate profits to GDP ratio will decrease in the long run, tending to its historical mean.

Reading 9: Economic Growth

LOS 9 (c) Explain why potential GDP and its growth rate matter for equity and fixed-income investors.