BQ Learning: What Drives Consumption And Investment

This is a series of explainers to educate and inform watchers of the economy. In association with Crisil as knowledge partner.

Recall from our first primer on national income accounts that gross domestic product, as measured through the demand side, aggregates the demand for goods and services by users — consumers, firms, the government, and rest of the world.

Thus, GDP = C + I + G + X - M

Where, C = private final consumption expenditure, I = investment demand (both, by private sector and government), G = government consumption expenditure, X = exports of goods, M = imports

To be sure, any of these sub-components can drive GDP. For most economies like India and the U.S., C and I are the largest drivers, whereas for others, exports drive a larger part of aggregate demand.

In India, C accounts for about 56% of GDP, and I about 36%. Hence, analysing the components and determinants of C and I, and in turn, how government policies can impact them, is important to understand what drives GDP growth itself.

‘C’ captures final expenditures by households on goods and services. This is further bifurcated by purpose of expenditure (such as food, clothing, health, education) and by durability (durable goods, non-durable goods and services).

‘I’ is officially termed as gross capital formation. This is further divided into: (a) gross fixed capital formation (which captures spending on fixed assets); (b) changes in stocks of inventories; and (c) spending on valuables (such as gold).

C: Households have a budget constraint and allocate their income between consumption and savings. Hence, current income levels affect households’ decisions to spend on goods and services in the period under consideration. Higher expected future income too leads to higher current consumption.

However, if there is uncertainty related to income, households will accordingly pare down current consumption and save instead.

Another determining factor is the interest rate. A higher interest rate (say on bank deposits or market securities) will incentivise households to allocate more income towards savings and less on spending. Of course, spending on essential goods (like food, clothing, rent etc.) is relatively inelastic to the interest rate, and more impacted by income level.

I: Firms’ decisions to invest in building up capital stock is largely determined by the expected rate of return on the investment. This, in turn, is influenced by the demand outlook on the economy — whether it is expected to grow, or uncertainty prevails.

Another major aspect is the cost of finance. A higher cost of finance (i.e., the interest rate) disincentivises firms to borrow in order to invest. Apart from cost, ease of access to finance, be it through banks, or equity or bond markets, influences investment decisions.

The ease of doing business, in the form of regulatory environment, say in terms of company registration, access to inputs (land, electricity), taxes, etc. are also factored in by firms before investing.

Lastly, public sector investment, which forms about 24% of the ‘I’ component in GDP for India, is determined by government policy and prevailing phase of business cycle in the economy.

Both fiscal and monetary policy can influence growth in C and I.

To boost C, the government could use fiscal policy to raise incomes of households. It could spend on areas that create employment, such as on the national rural employment guarantee programme, or infrastructure and construction. Or it could use the tax policy to influence income available with households (for instance, through altering income tax rates). It could also provide targeted support to certain segments of population, for instance, free foodgrain to the poor.

Fiscal policy comes in handy to spur growth in I, too. The government could directly undertake public investment or provide incentives to the private sector. Government infrastructure spending, such as on roads, metros, bridges and so on can attract, or ‘crowd in’ corporate investment. Additionally, such spending also creates employment and boosts income and consumption demand overtime. Alternatively, the government could use tax incentives (such as the production-linked incentive scheme).

Monetary policy can influence C and I demand by altering the availability and cost of funding. By cutting repo rate, the Reserve Bank of India aims to reduce the cost of borrowing for households and corporates, as banks and other financial institutions are expected to take the cue and lower their lending rates. The RBI also uses liquidity management tools such as its liquidity adjustment facility and open market operations to influence the quantum of money available in the economy — which eventually influences money supply and credit growth.