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Everybody knows that the unemployment rate today is 9.1%. Common knowledge is that, to create jobs and to reduce unemployment, the economy should begin to grow much faster than its current, anemic 1.3% rate.
But what are our expectations? How fast should the economy actually grow? These two questions embody several key considerations; including understanding how growth is computed in the context of inflation, what is potential growth, and how fast is too fast.
For the layperson who hears about China’s and India’s economies growing above the 9.0% and 8.0% rate, respectively, it is bothersome to hear that the U.S. economy is growing so slowly. Clearly, the U.S. economy should be able to grow faster.
The U.S. economy can grow faster. However, a key question to ask is how does one measure growth? There are two basic steps to measuring growth. First, one measures output (the value of all final goods and services produced in the economy) at current market prices. The second step is removing inflation. Removing inflation helps us identify increases in real output or the actual quantity of goods and services produced.
For example, if you are told that output increased to 110 this year from 100 last year, then what was the growth rate? An economist will tell you that it depends. If 10 items were produced at a price of 10 each last year and if 11 items were produced this year at a price of 10, then growth has been 10%. On the other hand, if this year the number of items produced remained at 10, but the price of each item rose by 10% to 11, then there has been no real growth. Essentially, to obtain real growth, we must subtract inflation from growth at market prices (i.e., nominal growth).
Now that we understand the relationship between real growth and inflation, we can now turn to potential growth. Recognize that growth at different economy sizes can be quite different. That is, 10% growth for an economy that has size 10 is only 1. However, 10% growth for an economy that has size 100 is 10. Therefore, it is easier to grow fast when you have a small economy than it is to grow rapidly when an economy is large.
In reference to China’s and India’s economy, China’s economy is valued in the $5-to-$6 trillion range. India’s economy is even smaller at about $1.5 trillion. The US economy, on the other hand, is nearly $15 trillion.
Many economists argue that the U.S. economy should be growing at about a 3.5% rate. Given our current inflation rate of about 3.0% based on the Consumer Price Index, the US economy must grow 6.5% at market prices in order to experience 3.5% real growth. Given a $15 trillion economy, that means the U.S. economy must add over $900 billion in new output at market prices to achieve about 3.5% real growth.
Looking at gross domestic product statistics from the U.S. Bureau of Economic Analysis, U.S. Department of Commerce, the U.S. economy has not produced this level of nominal growth at any point over the last 20 year. The nation’s largest growth year during this period in nominal terms was $769.7 billion (6.5%) in 2005. Inflation was 3.3% that year, so we experienced 3.1% real growth. Maybe we should not count on 3.5% growth.
In and of itself, growth is not always peaches and cream. If the economy begins to grow fast, inflation can arise. As output expands, there is upward price pressure on resources. Because we must subtract inflation when measuring real growth, a faster economy (at market prices) accompanied by a higher rate of inflation means that real growth may not accelerate so sharply.
Although we may have every reason to want the U.S. economy to grow faster to help reduce unemployment, and even though that expectation is fueled by fast growth in other economies, there are limits to how fast the U.S. can or should grow—at least as evidenced by growth rates over the past 20 years.
How fast should the economy grow? Like most other economists, my answer is, “As fast as possible without generating high inflation, because inflation is a genie that you don’t want to let out of the bottle.”
Dr. B.B. Robinson is an economist and director of BlackEconomics.org, a resource for economic concepts, issues and policies affecting African-Americans.