Monday, March 17, 2014

Opinion: GDP components and cash flow

Here is a simplified formula of calculating GDP. 

GDP = Private Consumption + Govt. Spending + Investments + (Exports-Imports)

So GDP has basically five components. The consumption or spending (both by Private and Govt.) is the biggest component of GDP, contributing approximately 70% to GDP. This consumption demand is partially met by producing those goods & services internally, fueling investments within the system. And some portion of this consumption demand is met by importing resulting in a negative cash flow. Any surplus goods or services exported bring a positive cash flow to the system.

Cash flow of GDP components for a nation

Biggest component of GDP, Private and Govt. spending, can expand or shrink based on what is happening with investments. When investments grow, new jobs are created, it brings more people under tax net and helps both Govt. and private spending to grow further. If consumption demand is met by increasing imports and less by investments, it creates jobs elsewhere draining cash from the system, so limits the expansion of an economic system.

Let us see what the data is for India during the last decade.

Source: RBI data
During 2000 to 2007, investments were distinctively higher than imports. It was self-reinforcing, GDP grew at a healthier rate.  During the last two years, investments slowed and were less than imports. It was self-defeating, resulted in a slower growth of GDP.