Interest rates and economic growth

Abstract

Each year the Board of Trustees of the Old-Age, Survivors and Disability Insurance (OASDI) Trust Funds projects the future financial status of the programs extending as far as 75-years into the future. These projections incorporate anticipated trends in both demographic and economic determinants of future costs. Particularly with regard to the economic determinants, the Trustees rely on past trends to project the future, and the projections of individual elements are largely independent of one another. This paper explores the long-term determinants of interest rates, and, in particular, the relationship between variations in interest rates and the rate of economic growth. Is there a positive correlation, as suggested by standard growth theory, or is the role of economic growth overshadowed by a larger array of domestic and foreign influences. Data from a number of large economies are used to demonstrate the influence of foreign interest rates in an increasingly globalized world capital market. A method is developed to adjust both long and short-term interest rates for expected inflation. The paper suggests that capital markets are highly integrated at the global level and that it makes little sense to model, analyze, or forecast interest rates within a closed-economy framework. Furthermore, there is only a weak relationship between real interest rates and economic growth. Given the complexity of global economic developments, it is unlikely that the OASDI projections can be improved by more formal efforts to model future interest rate changes.