Gross Domestic Product: The Main Determinants

The main determinants of gross domestic product (GDP) are consumption, investment, government expenditure, and net export. GDP is the total aggregate demand (AD) of an economy. AD for goods and services are not constant and increase with increasing income. The consumption function (C) shows the relationship between consumption and income:

  • C = a + cY, where a>0 and 0<c<1.

Where a is the fixed level of consumption and c is marginal propensity to consume i.e. an increase in consumption per unit increase in income. Further, investment depends on rate of interest. With an increase in rate of interest, investment declines. Rate of tax affects income negatively, and thus consumption falls with increase in tax rate. Figure 1 shows the equation in a diagram.

Consumption function and Aggregate Demand
Figure 1: Consumption function and Aggregate Demand

Aggregate demand is the sum of consumption, investment (I), government expenditure (G), export (X) and import (M):

  • AD= C + I + (X – M)

This aggregate demand function is shown in figure 1 as AD = Y and the consumption function is drawn as C. as investment depends on rate of interest, the investment function can be shown as:

  • I = I(r), I’<0

When the rate of interest increases, it will reduce the investment. With an increase in interest, aggregate demand falls as investment decreases. Therefore, GDP reduces with an increase in interest rate. Figure 2 shows that with an increase in interest rate the income demanded from the given consumption function and investment declines.

Increase in interest rate
Figure 2: Increase in interest rate

With a decline in consumer confidence, the consumer demand for goods and services falls. This reduces the income of the whole economy. With decline in income, there is a further decline in the consumption of the economy. Thus, a multiplier effect causes a decline in consumption due to increase in income. This effect ultimately leads to a reduced GDP.

Consumption in a simple model is dependent on income (Y). However, with a government rate of tax, say t on income, then consumption becomes:

  • C = a + cY – tY = a + (c – t)Y

Given a fixed government expenditure and net export (NX = X-M), we see that the aggregate demand function becomes:

  • AD= a+ (c-t)Y + I(r) + G + NX

This indicates that with an increase in rate of tax, the consumption will be dependent on the coefficient (c-t). With an increase in t, (c-t) will fall, thus, reducing consumption and AD, leading to a decline in GDP. Thus with an increase in the rate of tax, there is a decline in GDP.

Government expenditure is assumed to be fixed. A higher level of government expenditure will lead to an increase in exogenous expenditure of the economy, and thus will result in increase in income, leading to a higher level of aggregate demand. This would lead to a greater GDP.

With an increase in the exchange rate, i.e. the increase of the value of the home currency, trade with the country would be less profitable and the products produced in the home country would become dearer for purchasers abroad. So if more goods can be purchased for the same amount of dollar, then the exchange rate of dollars has increased and vice versa. This will lead to a reduced export for the country, as the exchange rate becomes higher. Further, with a higher exchange rate, domestic purchasers will have an advantage over foreign sellers, as they will gain the advantage of purchasing foreign goods at a lower price due to exchange rate advantage towards the domestic country. Thus, an increase in exchange rate will lead to an increase in GDP. Therefore, if net export increases with an increased exchange rate, GDP will increase, and net export reduces, GDP will reduce.

Brent crude is important as it is used to price two thirds of internal oil prices. If there is an over dependence of the economy on imported oil, with will lead to an increase import prices with an increase in price of Brent Crude. Therefore, an increase in the price of Brent crude will lead to an increase to the import prices of the product. Increase in import will reduce net export or may even push it to negative, thus, leading to a decline in aggregate demand. This will reduce the consumption, as a decline in output will lead to a decline in consumption and will further result in decline of the aggregate demand and therefore GDP. Therefore, the import of crude will increase leading to a lesser net export assuming unaltered export. Therefore, there will be a decline in aggregate demand and GDP. Further, the decline in GDP of the economy with an increase in the price of crude will also depend on the degree of dependency of the economy on crude resources. Thus, higher the degree of dependency, higher will be a decline in GDP with increase in crude prices. Thus, an increase in the prices will lead to a higher import prices and therefore leading to a lower GDP.

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