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Role of Investment and Consumption
Context:
Economic growth can be compared to sailing on two interconnected boats—one representing the supply or production of goods and services and the other signifying demand or expenditure.
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- Gross Domestic Product (GDP) measures the value added by the production process.
- For sustained growth, both supply and demand must move in sync.
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- If supply lags behind demand, inflation occurs due to rising prices.
- Conversely, if demand weakens, businesses accumulate unsold inventories, leading to production cuts, job losses, and a downward economic spiral.
Four Pillars of Aggregate Demand
An economy’s demand, or aggregate expenditure, comes from four key sources:
- Private Consumption: Expenditures by individuals on essentials and discretionary items, such as food, clothing, and mobile phones.
- Private Investment: Spending by businesses and households on new machinery, factories, and residential buildings.
- Government Expenditure: This includes both consumption (such as salaries of public employees) and investment (such as infrastructure projects).
- Net Exports: The difference between a country’s exports and imports in global trade.
The multiplier effect is a key concept in economics that explains how an initial change in spending can lead to a larger overall impact on national income and economic activity.
Investment and the Multiplier Effect
- Investment: Among these, investment plays a crucial role due to its multiplier effect—where an initial investment stimulates additional economic activity.
- For example, an investment of ₹100 might raise GDP by ₹125, indicating a multiplier of 1.25.
- Infrastructure: Public infrastructure projects, such as highways, not only generate employment and incomes but also stimulate further development, such as the establishment of new businesses along the routes.
- The multiplier effect varies depending on the type of investment and the region’s economic conditions.
- Consumption: Compared to investment, consumption has a weaker multiplier effect.
- While higher incomes lead to increased consumption, the reverse is not as effective—higher consumption does not necessarily generate proportional income growth across the economy.
- Keynesian economists thus view consumption as a passive component of aggregate demand.
India vs. China: A Tale of Diverging Growth Paths
- In the early 1990s, India and China had nearly identical per capita incomes, with both countries at about 1.5% of the U.S. average.
- However, by 2023, China’s per capita income had grown to five times that of India (or 2.4 times when adjusted for purchasing power).
- As a percentage of U.S. per capita income, China reached 15% in 2023, while India stood at 3%.
- The key driver behind China’s rapid economic expansion has been its high investment rates.
- From the 1970s onward, China consistently maintained higher investment rates than India.
- By 1992, investment accounted for 39.1% of China’s GDP, compared to 27.4% in India.
- India briefly closed this gap in the early 2000s, with its investment rate peaking at 35.8% in 2007.
- However, the 2008 global financial crisis led to diverging policy responses.
- India’s investment rate declined after 2012, whereas China aggressively increased public investment, particularly in infrastructure, advanced manufacturing, and emerging technologies.
- By 2013, China’s investment rate stood at 44.5%, while India’s dropped to 31.3%. In 2023, these figures were 41.3% and 30.8%, respectively.
- India’s recent economic growth has been largely consumption-driven, with private consumption accounting for 60.3% of GDP in 2023, compared to 39.1% in China.
- The dominance of consumption reflects weaknesses in other components of demand—low investment levels, moderate government spending, and a persistent trade deficit, where imports exceed exports, dampening domestic demand.
Challenges of Consumption-Led Growth
- Slow Growth: A consumption-driven economy grows more slowly than one led by investment.
- Inequality: Moreover, it exacerbates income inequality.
- Lack of Jobs: Job creation and income growth remain sluggish for many Indians, leaving large sections of the population behind.
Need for Government-Led Investment
- In such a scenario, government intervention becomes essential.
- Public investment in critical sectors can restore business confidence, stimulate private investment, and ensure inclusive economic growth.
- However, recent government policies, including the latest Union Budget, have not demonstrated the necessary commitment to increasing investment.
- Instead, tax concessions and cautious government spending suggest a preference for low-growth, consumption-driven strategies that primarily benefit the middle and upper classes.
For India to achieve sustainable and equitable growth, a shift towards higher public investment is crucial. Strategic government spending can create a ripple effect, encouraging private investment and leading to broad-based economic development. Otherwise, India risks falling into a low-growth trajectory, limiting opportunities for millions and widening socio-economic disparities.
