Gross Domestic Product consists of outputs of all final goods and services. How are these used? The largest components is accounted for by private household consumption – food, clothing, fuels, and power, travel, personal services, durables and so forth. This is captured in private consumption expenditure. Next comes investment This consists of both additions fixed assets plant, equipment and structures as well as net increase of all kinds. The third component is government use of current goods and services captured in government expenditure on the same. A part of the domestic output is exported to foreign countries. But then we must also account for the act that private spending investment sending and government expenditure may also consists of some imported items which must be taken out. Thus we can visualize the following sources and uses identity:
GDP (Y) = Private Consumption (C ) + Investment (I)
+ Government Expenditure (G)
+ Exports (X) – Imports (M)
Keep in mind this is just an accounting identity – value of goods and services available from domestic production and imports must equal he value of goods and services used up for various purposes including net additions to inventories. We do not know yet what determines the volume of goods and services produced during a year. For that we must investigate determinants of spending decisions – C, I, G and X – on the hand and production decisions of producers on the other. In a market economy, demand and supply determine the volumes of output and its price.
Determinants of aggregate Spending:
Let us begin with the largest component of aggregate demand. Household consumption behavior has been studied extensively both in the aggregate as well as at the level of individual households. The most important influence on the household spending decisions is its current and past income levels, in particular what is known as personal disposable income (PDI) i.e. income that actually ends up in the hands of households after all the statutory deductions like income taxes. Every hundred rupees increase in income leads to approximately seventy-five-rupee increase in consumption expenditure for the economy as a whole though this proportion differs between different income groups. Spending volumes are also positively affected by accumulated wealth. Finally real returns to saving may also have some impact – e.g. high interest rates paid on deposits and debentures, attractive returns to investment in stocks etc., would probably induce households to spend less and save more. However, empirically this last factor has not been found to be very significant.
Determinants of investments spending have been inquired into both by economist and corporate finance specialists. The widely accepted theory of investments behavior postulates that investment by corporations depends primarily on expected changes in output, after-tax real cost of capital and availability of funds. Expectations of changes in output may be based partly on past changes in output. After tax cost of capital is determined by interest rates ad factors like investment tax credits, depreciation allowances and expected inflation. Availability of funds, in particular sufficient retained earnings appears to be an important factor even in the absence of capital rationing. Investment responds positively to expectations of increase in output and negatively to increase in cost of capital
Government expenditure is largely a policy variable. It responds partly to economic conditions and is partly influenced by non-economic factors. When the economy is depressed the government may deliberately increase its expenditure on goods and services to provide a stimulus for economic activity. Conversely when the economy is overheated discretionary expenditure may be curtailed though some items of mandatory expenditure such as salaries cannot be easily contracted.
A country’s exports will generally depend upon two major factors. The levels of economic activity and incomes in countries to which it exports would be the dominant consideration. If income levels in its foreign markets are high, a country’s exports would boom. The second factor would be the price its foreign consumers face in their respective currencies relative to the prices of its competitors. This would depend partly on the exchange rate. In the case of small countries exports are often treated as exogenous i.e. unaffected by economic conditions at home.