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Macroeconomic Determinants of Economic Growth in India: A Time series

Analysis

Article · June 2014

DOI: 10.15764/ER.2014.02006

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 SOP TRANSACTIONS ON ECONOMIC RESEARCH
ISSN(Print): 2372-3246 ISSN(Online): 2372-3254
VOLUME 1, NUMBER 2, JUNE 2014

SOP TRANSACTIONS ON ECONOMIC RESEARCH

Macroeconomic Determinants of Economic

Growth in India: A Time series Analysis
Sreelata Biswas1 * and Anup Kumar Saha2
1Visiting Faculty, Department of Economics, Chakdaha College, affiliated to University of Kalyani, West-Bengal, India.
2Assistant Professor, Department of Economics, Nabadwip Vidyasagar College, Dist-Nadia, Pin-741302. West-Bengal, India.
*Corresponding author: sonaeco@rediffmail.com

Abstract:
The study estimates the short-run as well as long-run macroeconomic determinants of country’s
economic growth by applying time series analysis. The Johansen and Juselius multivariate
co-integration test and the vector error correction (VEC) model are used to analyze the annual
data from 1980-81 to 2010-11. The empirical findings confirm that there is a stable long-run
relationship between India’s gross domestic product (GDP) and its determinants. The result
suggests that gross domestic capital formation, employment, export, foreign direct investment
and money supply have positive effect on India’s GDP growth where as inflation and fiscal deficit
have negative effect. In the short-run, GDP is significantly influenced by country’s gross domestic
capital formation. The error correction term is negative and significant. Further generalized
variance decomposition assures the prudent impact of export and capital formation on GDP in
India.
Keywords:
Economic Growth; Co-integration; VEC Model; India

1. INTRODUCTION

Growth is often considered as the end of all economic activities. So understanding the determinants
of growth is not only important from the policy perspective but also is the key component for macro
management. It is determined by internal as well as external macro variables of an economy such as
investment, employment, money supply, general price level, fiscal deficit, level of export, foreign capital
etc.
We will use an extended framework of neo-classical growth model while analyzing the growth deter-
minants. As our study is meant for a single country so the issue of conditional convergence as per the
neo-classical growth theory is irrelevant for us. Rather we will look for the determinants of growth which
has activated our growth process towards convergence since opening up of our economy.
The study is composed of the following sections. Section 2 has tried to depict the trend and structure of
economic growth in India for the last thirty years. The linkages between economic growth and related
macroeconomic factors are reviewed in Section 3. Section 4 describes the data and develops a framework
to perform time series analysis. The empirical results are provided and interpreted in Section 5. Finally
Section 6 concludes the paper.

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 Macroeconomic Determinants of Economic Growth in India: A Time series Analysis

2. GDP GROWTH AND INDIAN ECONOMY

Indian economy had succeeded to break the so-called ‘Hindu-rate’ of growth and moving towards
the East Asian nations and even in some cases challenging the G-8 nations. Now India is a leading
member among the emerging economies. The most honorable interpretation for this growth experience is
the pro-market interpretation of the economic liberalization of nineties [1]. The liberalization process
uncaged the so-called animal instinct of the Indian entrepreneurs resulting into manifold increase of
the efficiency in the capital utilization which is essential for higher rate of economic growth. But some
economic-historians don’t agree with the above view. It is being pointed out that the average annual
growth rate of Gross Domestic Product (GDP) hit the 5.6 per cent mark in the 1980s, well before the
launch of the July 1991 new economic reform. The decadal growth rate in the 1990s was not much higher
than the previous decadal growth rate. Therefore, opening up of the economy according to the I.M.F.
prescription could not be credited with the fact that it has made a significant difference to growth in India
[2]. But certainly the above view is very conservative in nature. Fragile growth of the 80’s is replaced by
the highly stable growth in the nineties only because of the systematic reforms in the Indian economy.
India has successfully recovered after the recent global financial crisis. Though growth has slowed down
recently.

3. ECONOMIC GROWTH AND OTHER MACROECONOMIC VARIABLES

Country’s economic growth is influenced by several macroeconomic variables like capital formation,
employment generation, export level, foreign capital, money supply, general price level, government
expenditure etc. These relations are reviewed in this section.

3.1 Growth and Capital formation

Theoretically the relation between capital formation and growth can be explained by ‘Q’ theory. As per
this theory capital formation acts as the main driving force of growth. Tobin argues that delivery lags
and increasing marginal cost of investment are the reasons why ‘Q’ would differ from its natural value.
Another approach dubbed as neoliberal [3] emphasizes the importance of financial deepening and high
interest rates in stimulating growth. The proponents of this approach are McKinnon [4] and Shaw [5]. The
core of their argument rests on the claim that developing countries suffer from financial repression which
is generally equated with controls on interest rates in a downward direction and that if these countries
were liberated from their repressive conditions, this would induce savings, investment and growth. Not
only will liberalization increase savings and loan able funds, it will result in a more efficient allocation
of these funds, both contributing to a higher economic growth. In the neoliberal view, investment is
positively related to the real rate of interest in contrast with the neoclassical theory. The reason for this
is that a rise in interest rates increases the volume of financial savings through financial intermediaries
and thereby raises investible funds, a phenomenon that McKinnon [4] calls the “conduit effect”. Thus,
while it may be true that demand for investment declines with the rise in the real rate of interest, realized
investment actually increases because of the greater availability of funds. This conclusion applies only
when the capital market is in disequilibrium with the demand for funds exceeding supply.
Basically capital acts as the most fundamental input in a production system. It provides the base of
growth of an economy. There exists a non-linear positive relation between capital formation and growth in
general depending on the degree of efficiency of the capital use within the economic system. So the level

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 SOP TRANSACTIONS ON ECONOMIC RESEARCH

of capital used within the economy is not only important but also the way it is used is also an important
determinant of growth. Appropriate choice of technique depending on the socio-economic condition is
the basis of optimization of growth. Several country level empirical studies [6–11] have found critical
linkage between capital formation and the rate of growth in Africa, Asia and Latin America. It is claimed
that even a little robust growth rate can be sustainable over a long period of time only when a country is
capable of maintaining capital formation at a sizeable proportion of GDP. It has been observed that any
proportion less that 27 per cent cannot sustain economic growth. It is estimated that the ratio of gross
capital formation to GDP in the sub-saharan African countries which has experienced poor growth in
the 1990s was less than 17 per cent compared to 28 per cent in advanced countries [6]. Again, the study
of [12] has showed that the proportion of capital formation to GDP that can sustain a robust economic
growth must not be less than 27 per cent and in some cases, it must go as high as 37 per cent.

3.2 Growth and Employment

Labour is one of the elementary factors in a production process. So growth-employment shares a

positive non-linear relation in general. Since labour is an accompanying factor with other factors so the
labour productivity generally follows the non-linear path. Non-linear relation is again supported by the
Marxian perspective of division of labour. The growth employment relation has become a critical issue
with the advent of the neo-liberal doctrine. The antagonists of the doctrine are of the view that the jobless
growth is the most dangerous social curse of globalization. More and more capital intensive production
with the development of technology and use of information and technology has lead to lesser employment
elasticity in most of the economies. Emergence of global capital has given birth of new generation of
global working class and a big unskilled labour class involved mostly in the informal sectors.
The challenges of globalization and economic liberalization have brought about new realities having
uncertain implications for employment creation in many developing nations [13]. Swane and Vistrand
[14] have found a significant and positive relationship between GDP and employment growth in Sweden
and they claimed jobless growth as a temporary deviation. Yogo [15] is of the view that the employment
issues in sub-Saharan Africa are mostly a matter of quality rather than quantity. As per his findings low
level of employment is primarily because of weak economic growth. Examining the relationship between
economic growth, employment and unemployment in the European Union (EU), Walterskirchen [16]
found a strong positive correlation between GDP growth and change in the level of employment. Since
the demand for labour is a derived demand, the expansion of real GDP for instance generates increased
derived demand for workers [17, 18].

3.3 Growth and Export

Exports widen the size of the market to the domestic producers and compel the producers to use more
effectively the abundant factor inducing to introduce more suitable technical know-how. According to
modern trade theory, gains from trade come from two independent channels: gains from exchange and
gains from specialization in production. For the sake of simplicity higher level of economic growth can
be approximated with the so called ‘gains’ of trade theory assuming the other aspects of development can
be directly followed with higher level of economic growth. Many trade theorists have argued that exports
lead to investment and investment, in turn, leads to higher capacity utilization and further investment,
which stimulates growth. It was found that countries with lower level of trade protection grow faster
than the countries with higher level of trade protection [19, 20]. Dowrick and Golley [21] found that an

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 Macroeconomic Determinants of Economic Growth in India: A Time series Analysis

increase in the overall trade share have long term benefits on economic growth.

3.4 Growth and Foreign Direct Investment (FDI)

It is expected that FDI promotes economic growth in developing countries through two major mech-
anisms: (i) by increasing total domestic investment, and (ii) by increasing productivity. Again FDI
raises productivity spillovers not by increasing the productivity of the company where it takes place
but that of other companies and the economy as a whole. This spillover effects may include human
capital, efficient cost structure, better infrastructure, positive business climate and so on [22]. According
to neoclassical theorists (e.g., [23]), FDI influences economic growth by increasing the amount of per
capita capital. It does not influence long-run economic growth because of diminishing returns to capital.
They argue that long run growth can only arise because of technological progress and/or population
growth which are completely exogenously determined. They also claim that FDI can affect growth if it
has positive and permanent impact on technology. On the contrary, recent endogenous growth theory
states that FDI expands long-run growth endogenously by increasing Total Factor Productivity (TFP) in
the production process [24, 25]. It also suggests that, through technology transfer to their affiliates and
technological spillovers to unaffiliated firms in the host economy, MNCs can speed up the development of
new intermediate product varieties, raise product quality, facilitate international collaboration on R&D,
and introduce new forms of human capital.
In their endogenous growth model Borensztein, Gregorio, and Lee [26] have identified the role of
FDI in enhancing economic growth. They analyzed FDI flows from industrial countries to sixty-nine
developing countries for the period of 1970-89 and found that FDI contributed more to domestic growth
via technology transfer than domestic investment. Using the cross section data Balasubramanyam, Salisu,
and Sapsford [27] investigated the effect of FDI on growth in six developing countries. They got two main
findings. First, growth enhancing effects of FDI are stronger in countries that pursued an policy of export
promotion rather than import substitution. Second, they find that, in countries with export promoting
trade regimes, FDI has a stronger effect on growth than domestic investment. In their panel data study for
23 developing countries from Asia, Africa, Europe and Latin America Basu, Chakraborty and Reagle [28]
found the causal relationship between GDP growth and FDI to run both ways in more open economies,
and in only one direction from GDP growth to FDI in more closed economies. On the contrary, many
empirical studies especially those using firm-level data, find no evidence that FDI promotes economic
growth and that FDI is no more productive than domestic investments [29]. Carkovic and Levine [30]
indicated FDI’s crowding out effect on local investment and also its adverse impact on the current account
of balance of payment. Generally, the more competitive the host country environment is, the greater the
likelihood of FDI developing linkages to the local economy, committing state-of-the-art technology and
know-how, disseminating the new technology within the host economy, and focusing on the export rather
than domestic market, and the lesser the ability of FDI to extract abnormal profits from the host economy
and to crowd-out domestic investment [31]. On the whole, whether FDI triggers economic growth or
economic growth brings FDI is a matter of controversy [32] and therefore this issue has been the subject
of empirical verification.

3.5 Growth, Inflation and Money supply

Growth-inflation relationship can be established with the help of different theories. In the classical
model, savings is the driving force of the growth, so the growth falls due to reduction of savings resulting

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 SOP TRANSACTIONS ON ECONOMIC RESEARCH

from wage and price rising. Therefore negative relationship between growth and inflation exists according
to the classical model. The relationship between economic growth and inflation is more prudent in
Keynesian theory [33]. In this theory, inflation can be due to demand-pull inflation or cost-push inflation.
Increase in aggregate demand due to increased private and government expenditure causes the demand-
pull inflation at the full employment level of output. Therefore demand-pull inflation is constructive to a
faster rate of economic growth since the excess demand stimulates more investment and expansion of
the overall capacity of the economy. On the contrary, increase in the production cost ultimately leads to
the inflationary pressure. Depreciation of the domestic currency also leads to the increase of the input
cost because of the rising import cost of the raw materials or any other capital equipment. So it is clear
that the ‘supply shock inflation’ is deterrent to the output growth. Monetarists claim that inflation is a
monetary phenomenon. But the relationship between inflation and output growth of real economy can
be easily drawn from the Quantity Theory of Money (QTM) illustrated by most of the monetarists like
Simon Newcomb [34], Irving Fisher [35], Pigoue [36] and finally Milton Friedman [37]. The QTM
provides an inverse relationship between inflation and output growth holding nominal money supply and
the velocity of money constant. The relationship between growth and inflation is mixed in nature in
neo-classical literature. Early neo-classical economists like Solow [23] and Swan [38] did not consider
price level as an endogenous variable in their growth model. They even did not mention about the price
level as an exogenous factor or within the purview of other factors affecting growth. So they were neutral
about the effect of inflation on growth. Mundell [39] was perhaps the first neo-classical economist who
had emphasized the impact of inflationary expectation on the growth. According to the Mundell model,
people accumulate more wealth if they expect that the price is going to be high in coming days. They
save more today to keep their value of wealth constant during the days of continuous price rise. So
inflationary-expectation increases the steady state level of capital of the economy. More investment
results into more output growth. Later, Tobin [40], another neo-classical economist, also supported the
Mundell’s view. We have seen historical evidence of inverse relationship between inflation and growth.
Now it is imperative to review the empirical literature of the causality between inflation and growth.
According to Fischer [41] inflation reduces the level of investment as well as productivity growth and
thereby total output growth. Bruno and Easterly [42] had studied 26 countries which faced very high
inflation rate, 40 per cent or above, at some point of time over the 1961-1992 period. They have found a
strong negative relationship between inflation and growth at the high inflation rates. The relation between
the two variables was found to be ambiguous at low or moderate level of inflation. But they had suggested
that inflation crisis is merely a cyclical phenomenon and it does not have any permanent effect on growth.
Ghosh and Phillips [43] have studied inflation-growth relationship for 145 countries considering almost
four decade long data set starting from 1960. They have come to the conclusion that there exists convex
non-linear relationship between inflation and growth following their numerous robustness checks analysis.
In their multivariate analysis they have established that the effect of inflation on growth decrease if other
variables affecting growth included into the model. At very low level of inflation (2-3 percentages),
growth and inflation are positively correlated. They have also pointed out that 2.5 per cent inflation is
the threshold level of inflation. There exists negative correlation between inflation and growth above this
level of inflation. Dewan and Hussein [44] found in a sample of 41 middle-income developing countries
that inflation was negatively correlated to growth. We now incorporate money supply as one of the most
important relevant variable in this context following the QTM. In fact QTM proposed by Friedman [37]
acted as the scientific beginning of the empirical search of the relationship between money, output and
price level. It got momentum following the work of Sims [45]. Working on the Romanian data for the
period 1992-2000, Budina et al. [46] found the weak exogeneity of output but significant amount of
short-run dynamics between money supply and inflation supporting the Monetarists’ proposition. Ashra
et al. [47] examined the relationship for the developing countries. Their findings indicate that there
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 Macroeconomic Determinants of Economic Growth in India: A Time series Analysis

exists bidirectional causality between money and price level and that money is non-neutral so that it is
not exogenous in the long-run. Grauwe and Polan [48] using a large panel of low- and high-inflation
countries found that the QTM prediction that an expansion of the money stock does not increase output
in the long-run was confirmed. Herwartz and Reimers [49] analysed the dynamic relationships between
money, real output and prices for an unbalanced panel of 110 economies and reported that particularly for
high inflation countries homogeneity between prices and money could not be rejected. They suggested
that central banks, even in high inflation countries, can improve price stability by controlling monetary
growth. Working on Indonesian economy, using annual data series for the period 1952-2002, Hossain
[50] reported weakly co-integrated relationship between the consumer price index (CPI), the stock of
narrow (M1 ) or broad money (M2 ) and real permanent income. Abbas and Husain [51] studied the causal
relationship between money and income and between money and prices in Pakistan. They had applied
co-integration, error correction model and standard Granger causality test on an annual data set for the
period 1959-2002. Their investigation confirmed the long-run relationship among money, income and
prices. The relationship is unidirectional from income to money in the long run and bidirectional between
money supply and price. Muhd Zulkhibri (2007) examines the causality relationship between monetary
aggregates, output and prices in the case of Malaysia. The study used a vector auto regression (VAR)
model applying the Granger no-causality procedure developed by Toda and Yamamoto [52]. The results
indicate a two-way causality running between monetary aggregates, M2 and M3 and output which is
consistent with theoretical conjecture by Keynesian and Monetarist views whereas there is a one-way
causality running from monetary aggregate, M1 and output. In addition, the results suggest that all
monetary aggregates have a strong one-way causality running from money to prices but no evidence for
the opposite causality. Thus, the results add the empirical support to the argument in the literature that
the relation between money supply, inflation and income growth is not a universal construct rather it is a
complex problem differs according to the macro-economic conditions of a nation.

3.6 Growth and Government expenditure

Government expenditure has both negative as well as positive impact on growth. Increased government
expenditure crowds out the available amount of investable surplus of an economy. So the capital available
to the private sectors reduces. That is why pro-globalists are in favor of minimum government. Govern-
ment expenditure is detrimental to growth if it is used for unproductive purposes such as administrative
purposes, interest payments etc. It will enhance growth if it is deployed for the productive purposes such
as discovery of an oil-basin, setting up of a technical university etc.

3.7 DATA DESCRIPTION AND MODEL SPECIFICATION

In this paper the long run equilibrium relationship between GDP and its fundamental macroeconomic
determinants has been analyzed through co-integration technique. The variables used as fundamentals
include: log of gross domestic capital formation (GDCF) taken as a proxy for physical capital; log
of employment in public and organized private sectors (EM) taken as a proxy for labour force; log of
export (EX) of goods and services; log of foreign direct investment inflow (FDI) as an important foreign
inflow; log of broad money i.e., M3 taken as money supply (MS); log of whole sale price index for
all commodities (WPI) taken as a measure of inflation; log of gross fiscal deficit (FD). The empirical
work uses annual data from 1980-81 to 2010-11 sourced from the Hand book of Statistics (2008-09 and
2012-13) published by the Reserve Bank of India and various issues of newsletter published by Secretariat

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 SOP TRANSACTIONS ON ECONOMIC RESEARCH

for Industrial Assistance (SIA). The summary statistics of the data used is appended at the end (See Table
11 in the Appendix). The following functional form between GDP and other related macro variables is
assumed as follows:

GDPt = b0 + b1 GDCF t + b2 EMt + b3 EX t + b4 FDI t + b5 MSt + b6W PI t + b7 FDt + et (1)

Where:
b 0 = constant or intercept term.
t = deterministic trend.
et = the stochastic error term.
The b s are the coefficients to be estimated. The expected signs for b 1 , b 2 , b 3 , b 4 , b 5 are positive, that
of b 6 and b 7 are negative.

4. METHODOLOGY AND EMPIRICAL ANALYSIS

4.1 Stationarity Tests

The classical regression model requires that the dependent and independent variables in a regression be
stationary in order to avoid the problem of what Granger and Newbold [53] called ‘spurious regression’.
Nonstationarity can be tested using the Augmented Dickey-Fuller (ADF) test, the Phillips Perron (PP)
test and the Kwiatkowski- Phillips-Schmidt-Shin (KPSS) test.

4.2 ADF Test

The test is conducted with the following set of regression equations

p
DYt = b1 + qYt 1 + gi  DYt i + et (2)
i=1

p
DeltaYt = b1 + b2t + qYt 1 + gi  DYt i + et (3)
i=1

Where Y is the variable under consideration, D is the first difference operator, t is the time or trend
variable, et is a pure white noise and p is the optimum number of lags on the dependent variable. The first
equation consists of drift whereas the second equation includes both drift and a deterministic trend.

4.3 Phillips Perron (PP) Test

Dickey-Fuller test requires that the error term be serially uncorrelated and homogeneous while the
Phillips-Perron test is valid even if the disturbances are serially correlated and heterogeneous. The test
statistics for the Phillips-Perron test are modifications of the t-statistics employed for the Dickey-Fuller
test but the critical values are precisely those used for the Dickey-Fuller test. The PP test is carried out
with the help of the following two regression equations

4Y t = b1 + qYt 1 + ut (4)

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 Macroeconomic Determinants of Economic Growth in India: A Time series Analysis

DYt = b1 + b2t + qYt 1 + ut (5)

Here ut is a white noise error term and all other symbols have their usual meanings.

4.4 KPSS test

KPSS test assumes that the series yt with T observations ( t = 1,2,. . . ,T) can be decomposed into the
sum of a deterministic trend, random walk and stationary error

yt = dt + rt + et (6)

Where rt is a random walk

rt = rt 1 + µt

Where rt is a random walk and µt is independently and identically distributed with mean zero and
variance s 2 µ .
The initial value r0 is fixed and serves the role of an intercept. The stationarity hypothesis is s 2 µ = 0.
If we set d = 0, then under the null hypothesis yt is stationary around a level (r0 ).
The KPSS test statistic is the Lagrange multiplier (LM) or score statistic for testing null hypothesis H0 :
sµ 2 = 0 i.e., the time series is stationary, against the alternative hypothesis that H1 : sµ 2 > 0 i.e., the series
in non-stationary and in this ground this test differs from ADF and PP tests.
The results of all the three tests at level are provided in Table 1 and Table 2. The results indicate
that all the variables do not hold the same degree of integration. All time series having intercept are
non-stationary at level but GDP, EX and WPI series are stationary only for KPSS test. Again EM and WPI
series are non-stationary at level in case of test equation considering both constant and linear trend while
the other variables are stationary only for KPSS test. So we conduct all the tests using the first difference
of the variables. The results are provided in Table 3 and Table 4. The results indicate that all the variables
are stationary in their first difference form. But specifically in first difference form GDP is stationary
only for KPSS test; EX and WPI are stationary for PP and KPSS tests. According to Enders [54] and
Asterious & Hall [55], in the multivariate case co-integration analysis is applicable for a set of variables
with different orders of integration and this is called multi co-integration. So, in this study We have used
the Johansen multivariate co-integration test [Johansen [56, 57]; Johansen and Juselius [58–60]] to make
sure whether there is any long-run relation or not between GDP and other macroeconomic variables.

4.5 Determination of Lag-length

In the next step to determine the optimum lag length for co-integration test we use the standard criteria
of lag length selection (Table 12 in Appendix). Given limited sample size of 31 all the criteria are
suggesting the lag-length as 1, so we have selected 1 as our lag length for the analysis.

4.6 Co-integration Test and Vector Error Correction Model (VECM)

In order to establish the relationship between growth of GDP and its short-run and long-run macroeco-
nomic determinants the Johansen multivariate co-integration methodology [56, 59], which results in the
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 SOP TRANSACTIONS ON ECONOMIC RESEARCH

Table 1. Test of Stationarity in Levels (Intercept)

Variables ADF PP KPSS
GDP 0.398 [1] (0.9794) -0.207 [3] (0.9271) 0.734 [4]
GDCF 0.153 [0] (0.9646) 0.383 [6] (0.9788) 0.731 [4]**
EM -1.182 [1] (0.6683) -2.508 [4] (0.1236) 0.567 [4]**
EX -0.174 [2] (0.9310) 0.372 [1] (0.9782) 0.726 [4]
FDI -1.542 [0] (0.4990) -1.542 [0] (0.4990) 0.705 [4]**
MS 0.334 [1] (0.9761) 0.493 [1] (0.9836) 0.735 [4]**
WPI -1.463 [0] (0.5382) -1.112 [4] (0.6976) 0.726 [4]
FD -0.797 [0] (0.8055) -0.707 [8] (0.8302) 0.738 [4]**
Variables ADF PP KPSS
GDP -2.118 [1] (0.5147) -1.712 [3] (0.7207) 0.122 [4]
GDCF -2.573 [0] (0.2942) -2.573 [0] (0.2942) 0.074 [3]
EM -2.417 [2] (0.3634) -2.4 [4] (0.3721) 0.155 [4]**
EX -2.842 [2] (0.1954) -2.160 [2] (0.4931) 0.078 [4]
FDI -3.0 [0] (0.1540) -3.0 [0] (0.1540) 0.066 [2]
MS -3.0 [1] (0.1591) -1.572 [0] (0.7800) 0.079 [3]
WPI -2.827 [4] (0.2007) -1.275 [4] (0.8750) 0.155 [4]**
FD -3.0 [0] (0.1721) -2.810 [3] (0.2047) 0.117 [2]

Table 2. Test of Stationarity in Levels (Intercept and Linear Trend)

Variables ADF PP KPSS
GDP -2.118 [1] (0.5147) -1.712 [3] (0.7207) 0.122 [4]
GDCF -2.573 [0] (0.2942) -2.573 [0] (0.2942) 0.074 [3]
EM -2.417 [2] (0.3634) -2.4 [4] (0.3721) 0.155 [4]**
EX -2.842 [2] (0.1954) -2.160 [2] (0.4931) 0.078 [4]
FDI -3.0 [0] (0.1540) -3.0 [0] (0.1540) 0.066 [2]
MS -3.0 [1] (0.1591) -1.572 [0] (0.7800) 0.079 [3]
WPI -2.827 [4] (0.2007) -1.275 [4] (0.8750) 0.155 [4]**
FD -3.0 [0] (0.1721) -2.810 [3] (0.2047) 0.117 [2]

VECM, is used. The VECM is an extension of VAR model developed by Johansen and Jesulius [59] and
Johansen [57]. Now we specify VECM of order k in equation (7) as:

Table 3. Test of Stationarity in First difference (Intercept)

Variables ADF PP KPSS
GDP -2.467 [0] (0.1336) -2.50 [2] (0.1257) 0.096 [3]
GDCF -6.112 [0] (0.0000)*** -6.4 [5] (0.0000)*** 0.096 [5]
EM -3.771 [0] (0.0080)*** -3.822 [3] (0.0071)*** 0.050 [4]
EX -2.487 [1] (0.1293) -5.425 [2] (0.0001)*** 0.114 [1]
FDI -5.292 [0] (0.0002)*** -5.319 [3] (0.0002)*** 0.079 [3]
MS -3.528 [0] (0.0143)** -3.426 [4] (0.0181)** 0.088 [1]
WPI -1.941 [1] (0.3099) -3.913 [3] (0.0057)*** 0.185 [4]
FD -5.583 [1] (0.0001)*** -5.734 [5] (0.0001)*** 0.145 [7]

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 Macroeconomic Determinants of Economic Growth in India: A Time series Analysis

Table 4. Test of Stationarity in First difference (Intercept and Linear Trend)

Variables ADF PP KPSS
GDP -2.35 [0] (0.3961) -2.372 [2] (0.3854) 0.090 [3]
GDCF -6.024 [0] (0.0002)*** -6.291 [5] (0.0001)*** 0.105 [6]
EM -3.535 [0] (0.0541)* -3.647 [3] (0.0430)** 0.128 [4]*
EX -2.428 [1] (0.3584) -5.359 [2] (0.0008)*** 0.103 [1]
FDI -5.228 [0] (0.0011)*** -5.241 [3] (0.0011)*** 0.066 [3]
MS -3.847 [6] (0.0322)** -3.385 [4] (0.0731)** 0.077 [1]
WPI -3.134 [4] (0.1204) -3.895 [3] (0.0254)** 0.083 [4]
FD -5.474 [1] (0.0007)*** -5.625 [5] (0.0004)*** 0.14 [8]*
Notes: [.] denotes the lag(s) suggested by Schwarz Information Criterion (SIC) for ADF tests and by Newy-west using Bartlett
Kernel for PP and KPSS tests. (.) is p-value. ***, **, and * denote the rejection of the null hypothesis of a unit root at 1%, 5%, and
10%, respectively.

k 1
DZ = d + Â Gi DZt i +PZt k +yXt +ut (7)
i=1

With Gi ⌘ (Ai+1 + . . . . . . +Ak ), i = 1, 2,. . . . . . ,(k 1) and P⌘ (I Ai ... · · · Ak )

Where Zt is a (n⇥1) vector of jointly determined non-stationary I(1) endogenous variables such that
?Zt = Zt Zt 1 . Again, Gi 4Z t i ?is the vector autoregressive (VAR)
component in first difference. PZt k implies error-correction components. Xt is a (q⇥1) vector of
stationary I(0) exogenous variables. d is a (n⇥1) vector of parameters (intercepts). ut is the n ⇥ 1 vector
of independently normally distributed. Y is an (n⇥q) matrix of parameters. Gi is an (n ⇥ n) matrix of
short term adjustment coefficients among variables with k-1 number of lags. P is an (n ⇥ n) long-run
impact matrix of error-correction mechanism. The rank of P i.e., R(P) provides the basis for determining
the existence of co-integration or long-run relationship among the variables. There are three possibilities
with regard to R(P) : (i) if R(P) = 0, then the variables are not co-integrated and the model is equivalent
to a VAR model in first differences. (ii) if 0<R(P)<n, then the variables are co-integrated and (iii) if R(P)
= n, then the variables are stationary and the model is equivalent to a VAR model in levels. Since the term
PZt k provides information about the long-run relationship among the variables in Zt , the P matrix can
be decomposed into the product of two matrices a and b such that P = ab where a = an (n⇥r) matrix
which represents the speed of adjustment coefficient of the error-correction mechanism and b = an (n⇥r)
matrix of co-integrating vectors represents up to r co-integrating relationship in the multivariate model
which represent long-run steady solutions. In addition, Johansen [58, 59] suggested two test statistics,
namely the trace test statistics (l trace) and the maximum eigenvalue test statistics (l max). The trace
statistic tests the null hypothesis that the number of distinct co-integrating vector is less than or equal to q
against a general unrestricted alternatives q = r. The test is calculated as follows:

ltrace(r) = T Â i=r+1 ln(1 lbt ) (8)

Where T is the number of usable observations, and the l t ,s are the estimated eigenvalue from the
matrix. The Second statistical test is the maximum eigenvalue test (l max) and it tests the null hypothesis
that there is r of co-integrating vectors against the alternative r+1 co-integrating vectors. It is calculated
according to the following formula:

l max(r, r + 1) = T ln(1 lr+1 ) (9)

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 SOP TRANSACTIONS ON ECONOMIC RESEARCH

Table 5. Johansen’s Co-integration Test (Assuming intercept (no trend) in co-integration equation and test VAR)
Hypothesized No. of CE(s)
l tracetest Eigen values Trace Statistic 5 per cent critical value Probability**
None * 0.945528 287.3420 159.5297 0.0000
At most 1 * 0.904371 202.9500 125.6154 0.0000
At most 2 * 0.795338 134.8787 95.75366 0.0000
At most 3* 0.703429 88.87333 69.81889 0.0007
At most 4* 0.644472 53.62471 47.85613 0.0130
At most 5 0.386814 23.63433 29.79707 0.2163
At most 6 0.276311 9.450811 15.49471 0.3253
At most 7 0.002493 0.072395 3.841466 0.7879
l maxtest Eigen values Max –Eigen Statistic 5 per cent critical value Probability**
None * 0.945528 84.39207 52.36261 0.0000
At most 1 * 0.904371 68.07122 46.23142 0.0001
At most 2* 0.795338 46.00541 40.07757 0.0096
At most 3* 0.703429 35.24863 33.87687 0.0341
At most 4* 0.644472 29.99037 27.58434 0.0241
At most 5 0.386814 14.18352 21.13162 0.3502
At most 6 0.276311 9.378416 14.26460 0.2560
At most 7 0.002493 0.072395 3.841466 0.7879
Note: Trace statistic (l trace ) test indicates five co-integration and Maximum-Eigen Statistic (l max ) test indicates five co-integrating
equation at the 0.05 level. * denotes rejection of the hypothesis at the 0.05 level. ** MacKinnon-Haug-Michelis (1999) p-values.

Table 5 reports the results of Johansen’s multivariate co-integration maximum likelihood tests. Both
the trace test statistics and the maximum eigenvalue test statistics fail to reject the null hypothesis of the
existence of five co-integrating equations at 5% level of significance. Hence, it could be concluded that
there exists a stable long-run relationship of India’s GDP with its macro-economic determinants.
The normalized GDP co-integration equation is shown by the following equation

GDP = 41.068 + 1.867GDCF + 16.217EM + 0.956EX + 0.226FDI + 1.384MS 4.874W PI 3.038FD

(10)
The above normalized co-integration equation indicates that gross domestic capital formation, employ-
ment, export, foreign direct investment and money supply have positive effect on India’s GDP growth
where as inflation and fiscal deficit have negative effect. The estimated coefficients of gross domestic
capital formation, employment, foreign direct investment, inflation and fiscal deficit are statistically
significant at 1 per cent level; the estimated coefficients of export and money supply are statistically
significant at 10 per cent level. Since all the variables are estimated in natural logarithm, hence, the
estimated coefficient of each parameter can be interpreted as long run elasticity of GDP with respect to the
other related macro variables. The outcomes show that GDP is elastic to GDCF, EM, EX, MS, WPI and
FD as elasticities of these variables have magnitudes greater than one, implying India’s GDP does respond
strongly to the changes in these variables. But on the other hand GDP is comparatively less elastic to FDI.
Before conducting VEC model we perform diagnostic tests for the statistical accuracy of VECM
residuals. The results given in Table 6 and Table 7 confirm that the VEC residuals are white- noise i.e.,
the residuals are multivariate normal under the VEC residual JB normality test and they are not serially
correlated. Table 8 presents the short-run dynamic relationship and the short-run speed of adjustment
coefficient, ECM(-1), for GDP. It indicates the error correction or built-in adjustment mechanism such that
GDP may deviate from its long run equilibrium temporarily, however the deviation is adjusting towards
64
 Macroeconomic Determinants of Economic Growth in India: A Time series Analysis

Table 6. VEC RESIDUAL NORMALITY TESTS

Orthogonalization: Residual Covariance (Urzua)
Null Hypothesis: residuals are multivariate normal
Included observations: 29
Component Jarque-Bera df Prob.
GDP 5.439626 2 0.0659
GDCF 1.364566 2 0.5055
EM 6.831376 2 0.0329
EX 2.357027 2 0.3077
FDI 24.17215 2 0.0000
MS 7.270702 2 0.0264
WPI 3.975655 2 0.1370
FD 6.790463 2 0.0335
Joint 215.9997 450 1.0000

Table 7. VEC Residual serial Correlation LM Tests

Null Hypothesis: no serial correlation at lag order h
Included observations: 29
Lags LM-Stat Prob
1 57.04873 0.7186
2 83.63508 0.0503
3 77.51417 0.1195
4 79.73891 0.0887
5 77.39971 0.1213
6 75.71482 0.1500
7 63.50236 0.4941
8 56.69057 0.7300
9 69.59624 0.2948
10 73.89077 0.1864
11 101.0852 0.0022
12 61.17740 0.5769
Probs from chi-square with 64 df.

equilibrium level in the long run. In the present study the estimated value of ECM(-1) is insignificant.
Except money supply, inflation and fiscal deficit all the short-run coefficients have the expected signs and
that of gross domestic capital formation is significant at 5 per cent level.
Now we have adopted the VEC Granger Causality/Block Exogeneity Wald Tests to examine the
short-run causal relationship among the variables. Table 9 indicates the results of causality test. The null
hypothesis of block exogeneity is rejected for equations of EM, EX, MS and FD in the mode; it indicates
each variable is jointly influenced by the other variables. We obtain eleven unidirectional causality as:

5. Generalized Variance Decompositions and Impulse Response Analy-

sis

The generalized variance decomposition and impulse response function are performed to study the
dynamic characteristics of every endogenous variable in the system. Variance decomposition is the
proportion of the n-periods-ahead forecast error variance of a variable attributing to another variable. Here
65
 SOP TRANSACTIONS ON ECONOMIC RESEARCH

Table 8. Estimation of ECM for GDP

Variable Coefficient Std. Error t-Statistic Prob.
ECM(-1) 0.002300 0.010679 0.215363 0.8318
D(GDP(-1)) 0.285902 0.242642 1.178290 0.2532
D(GDCF(-1)) 0.146523** 0.059764 2.451681 0.0241
D(EM(-1)) 0.420489 0.483883 0.868989 0.3957
D(EX(-1)) 0.071957 0.060296 1.193394 0.2474
D(FDI(-1)) 0.005158 0.005868 0.878955 0.3904
D(MS(-1)) -0.016390 0.301851 -0.054300 0.9573
D(WPI(-1)) 0.112007 0.224929 0.497967 0.6242
D(FD(-1)) 0.028818 0.024266 1.187600 0.2496
Constant 0.046557 0.054740 0.850511 0.4056
R-squared 0.557912 Mean dependent var 0.131724
Adjusted R-squared 0.348501 S.D. dependent var 0.027001
S.E. of regression 0.021794 Akaike info criterion -4.547554
Sum squared resid 0.009025 Schwarz criterion -4.076072
Log likelihood 75.93953 Hannan-Quinn criter. -4.399892
F-statistic 2.664204 Durbin-Watson stat 1.942977
Prob(F-statistic) 0.034533
***, **, and * denote the rejection of the null hypothesis at 1%, 5%, and 10%, respectively.

(i) D (GDCF) ! D (GDP)

(ii) D (EX) ! D (GDCF)
(iii) D (FDI) ! D (GDCF)
(iv) D (GDCF) ! D (EM)
(v) D (FD) ! D (EM)
(vi) D (GDP) ! D (EX)
(vii) D (FD) ! D (EX)
(viii) D (EM) ! D (MS)
(ix) D (FD) ! D (MS)
(x) D (GDP) ! D (FD)
(xi) D (WPI) ! D (FD)

we measure the proportion of the forecast error variance of GDP that can be explained by shocks given to
its macro determinants. The impulse response function is used to measure the time profile of the effect of
shocks at a given point in time on the future values of endogenous variables of a dynamic system. The
result of variance decomposition of GDP for a 10-month time horizon is provided by Table 10. For our
model at the end of the 10-month forecast horizon, around 76.5 per cent of the forecast error variance of
GDP is explained by its own innovations. EX, GDCF, WPI, FD and EM explain about 9.5 per cent, 6.2
per cent, 4.1 per cent, 1.4 per cent and 1.0 per cent of the total variation after 10 months respectively but
the other variables (EM, FDI) have negligible impact on GDP during the same time horizon.
The forecast error variance decompositions only give us the proportion of the forecast error variance
of GDP that is explained by its determinants. They do not indicate the direction (positive or negative)
or the nature (temporary or permanent) of the variation. Thus, the impulse response analysis is used
to analyze the dynamic relationship among variable. Impulse responses of GDP are shown in Figure
1. In this figure, the horizontal axis denotes the lag period of impulse (Unit: year) and the vertical axis
denotes the response of impulse. The direction of change observed in the impulse response in each graph
(excluding WPI and FD) conforms to the sign obtained earlier in the co-integrating vector. Now, for GDP,
through the analysis of Figure 1 we can get: GDP will increase at decreasing rate throughout the period
66
 Macroeconomic Determinants of Economic Growth in India: A Time series Analysis

Table 9. VEC Granger Causality/Block Exogeneity Wald Test Results

Dependent Variables Excluded Chi-sq Df Probability
D (GDP) D (GDCF) 6.010739 1 0.2472
D (EM) 0.755142 1 0.0142**
D (EX) 1.424190 1 0.3849
D (FDI) 0.772561 1 0.2327
D (MS) 0.002948 1 0.3794
D (WPI) 0.247971 1 0.9567
D (FD) 1.410395 1 0.6185
ALL 9.076680 7 0.2350
D (GDCF) D (GDP) 2.630106 1 0.1049
D (EM) 0.444283 1 0.5051
D (EX) 4.085960 1 0.0432**
D (FDI) 5.129460 1 0.0235**
D (MS) 0.009413 1 0.9227
D (WPI) 1.503132 1 0.2202
D (FD) 0.586533 1 0.4438
ALL 11.43034 7 0.1209
D (EM) D (GDP) 0.543108 1 0.4611
D (GDCF) 4.146306 1 0.0417**
D (EX) 2.302554 1 0.1292
D (FDI) 1.019445 1 0.3127
D (MS) 0.870580 1 0.3508
D (WPI) 2.185341 1 0.1393
D (FD) 8.984707 1 0.0027***
ALL 17.93312 7 0.0123**
D (EX) D (GDP) 3.783897 1 0.0517*
D (GDCF) 1.978315 1 0.1596
D (EM) 0.490721 1 0.4836
D (FDI) 0.419667 1 0.5171
D (MS) 0.695862 1 0.4042
D (WPI) 0.035534 1 0.8505
D (FD) 5.392063 1 0.0202**
ALL 19.91966 7 0.0057***
D (FDI) D (GDP) 0.026932 1 0.8696
D (GDCF) 0.248540 1 0.6181
D (EM) 1.351924 1 0.2449
D (EX) 1.722021 1 0.1894
D (MS) 1.756608 1 0.1850
D (WPI) 0.953827 1 0.3287
D (FD) 0.900453 1 0.3427
ALL 5.874854 7 0.5544
D (MS) D (GDP) 1.419575 1 0.2335
D (GDCF) 0.788737 1 0.3745
D (EM) 4.142359 1 0.0418**
D (EX) 0.216075 1 0.6420
D (FDI) 0.160230 1 0.6889
D (WPI) 0.793059 1 0.3732
D (FD) 11.08860 1 0.0009***
ALL 17.64681 7 0.0137**
D (WPI) D (GDP) 0.850901 1 0.3563
D (GDCF) 0.041468 1 0.8386
D (EM) 0.197195 1 0.6570
D (EX) 0.106276 1 0.7444
D (FDI) 1.715284 1 0.1903
D (MS) 0.008899 1 0.9248
D (FD) 0.762638 1 0.3825
ALL 6.284947 7 0.5069
D (FD) D (GDP) 5.222153 1 0.0223**
D (GDCF) 0.309710 1 0.5779
D (EM) 1.706850 1 0.1914
D (EX) 2.575328 1 0.1085
D (FDI) 0.074230 1 0.7853
D (MS) 0.013288 1 0.9082
D (WPI) 2.952978 1 0.0857*
ALL 13.82559 7 0.0544*

Note: *, **, *** denote significant at 10%, 5% and 1% level respectively.

concerned. The immediate and permanent effects on GDP of a one standard deviation shock to GDCF
and EX are positive. They will follow the same pattern. In the short term (within three years) they will
rise sharply and in the next year they will fall; but after that in the long term (up to nine years) they will
remain flat. The impacts of a one standard deviation shock to EM and MS on GDP is positive and similar.
In the short term (within four years) they will increase rapidly and in the long term they will rise at a
decreasing rate. A one standard
deviation shock to FDI has a long term positive impact on GDP, though it is negative in some of the mid
periods. Again the immediate and permanent effects of a one standard deviation shock to WPI and FD are
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 SOP TRANSACTIONS ON ECONOMIC RESEARCH

Table 10. Variance Decomposition of GDP

Period S.E. GDP GDCF EM EX FDI MS WPI FD
1 0.021794 100.0000 0.000000 0.000000 0.000000 0.000000 0.000000 0.000000 0.000000
2 0.042531 89.81384 4.022615 0.647386 3.876443 0.307847 0.133638 0.699642 0.498586
3 0.064074 86.04175 4.911070 0.693366 5.428277 1.098752 0.156942 1.089408 0.580435
4 0.085627 83.39321 5.350034 0.765339 6.611656 1.178937 0.268908 1.661048 0.770865
5 0.106050 80.98864 5.708235 0.809294 7.636439 1.100461 0.370936 2.378505 1.007493
6 0.124693 79.31684 5.893265 0.855436 8.334113 1.031058 0.427087 2.976366 1.165833
7 0.141725 78.24872 6.006523 0.904753 8.755395 0.970059 0.457711 3.399445 1.257396
8 0.157457 77.48823 6.087750 0.944060 9.054962 0.919490 0.480628 3.700783 1.324103
9 0.172060 76.90821 6.150145 0.971179 9.284499 0.881249 0.497679 3.930194 1.376851
10 0.185672 76.46659 6.194706 0.991689 9.460605 0.852622 0.509975 4.106922 1.416891

positive towards GDP i.e., there will be co-existence of inflation, fiscal deficit and economic growth.

6. CONCLUSION

We have found that gross domestic capital formation, employment, export, foreign direct investment
and money supply have positive effect on India’s GDP growth where as inflation and fiscal deficit have
negative significant effect. GDP is found to be highly elastic to all the macro variables except foreign
capital. This is perhaps because of less openness of our economy compared to the other emerging
economies. The error correction test confirms the resilience of our GDP towards its long run equilibrium.
The resilience is also obtained from the impulse response analysis. So it can be concluded that the
successful and obviously the stable growth story of India during the last three decades is nothing but a
successful outcome of the judicious mix among the macro variables. That is why we have sailed through
the East Asian currency crisis and even the world wide global financial crisis successfully. Growth has
acted as the ultimate shield to all the macro imbalances.

APPENDIX

Table 11. Summary statistics, total sample

Variable No. of observations Mean Median Maximum Minimum Standard deviation Skewness Kurtosis Jarque-Bera Probability
GDP 31 13.822 13.93 15.8 11.83 1.185 -0.073 1.805 1.873 0.391935
GDCF 31 12.524 12.64 14.87 10.26 1.38 0.001 1.875 1.634 0.441674
EM 31 3.284 3.3 3.37 3.13 0.058 -0.903 3.174 4.255 0.119156
EX 31 11.307 11.57 13.95 8.81 1.602 -0.045 1.739 2.063 0.356481
FDI 31 8.654 8.88 12.16 4.15 2.232 -0.214 2.281 0.903 0.636542
MS 31 13.209 13.22 15.61 10.84 1.437 -0.007 1.816 1.81 0.404461
WPI 31 4.027 4.17 4.97 2.98 0.613 -0.216 1.714 2.376 0.304822
FD 31 10.92 10.92 12.89 8.94 1.075 -0.135 2.294 0.738 0.691452

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 Macroeconomic Determinants of Economic Growth in India: A Time series Analysis

Figure 1. Generalized Impulse Response Function of GDP

Table 12. Lag Length Criteria Results

Lag LogL LR FPE AIC SC HQ
0 178.3465 NA 1.62e-15 -11.35643 -10.98278 -11.23690
1 462.6797 398.0664* 7.85e-22* -26.04531* -22.68244* -24.96950*
* indicates lag order selected by the criterion
LR: sequential modified LR test statistic (each test at 5% level)
FPE: Final prediction error
AIC: Akaike information criterion
SC: Schwarz information criterion
HQ: Hannan-Quinn information criterion
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