Applied Macroeconomics: Employment, Growth and Inflation

by Vivek Moorthy

The economic factors affecting GDP or Aggregate Demand can be grouped into four categories: (a) Fiscal Policy: Government spending, taxes and subsidies, which are determined by the Treasury or the Finance Ministry. Higher government spending raises G and may stimulate C or I, while higher taxes (whether by changing tax rates or exemptions) lowers consumption, or C. (b) Monetary Policy: This is determined by the central bank, such as the US Federal Reserve or the Reserve Bank of India. Higher interest rates (and/or other factors such as the cash reserve ratio imposed on banks) lowers investment and the credit financed components of C, e.g., automobiles, housing, etc. (c) Exchange Rate: This can be affected by fiscal or monetary policy, or financial market developments, within the country or the rest of the world. A weak Rupee increases exports and reduces imports, and vice versa. (d) Independent of fiscal policy, monetary policy and the exchange rate, which are mostly policy related, AD changes because of independent, private business fluctuations. These independent fluctuations often have a bigger impact than the above three factors. We can break these down into three components. (i) Business sentiments: These are linked to current financial and psychological conditions and consumer confidence.