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Social Sci LibreTexts

14.1: The Role and Nature of Investment

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  • Learning Objectives

    1. Discuss the components of the investment spending category of GDP and distinguish between gross and net investment.
    2. Discuss the relationship between consumption, saving, and investment, and explain the relationship using the production possibilities model.

    How important is investment? Consider any job you have ever performed. Your productivity in that job was largely determined by the investment choices that had been made before you began to work. If you worked as a clerk in a store, the equipment used in collecting money from customers affected your productivity. It may have been a simple cash register, or a sophisticated computer terminal that scanned purchases and was linked to the store’s computer, which computed the store’s inventory and did an analysis of the store’s sales as you entered each sale. If you have worked for a lawn maintenance firm, the kind of equipment you had to work with influenced your productivity. You were more productive if you had the latest mulching power lawn mowers than if you struggled with a push mower. Whatever the work you might have done, the kind and quality of capital you had to work with strongly influenced your productivity. And that capital was available because investment choices had provided it.

    Investment adds to the nation’s capital stock. We saw in the chapter on economic growth that an increase in capital shifts the aggregate production function outward, increases the demand for labor, and shifts the long-run aggregate supply curve to the right. Investment therefore affects the economy’s potential output and thus its standard of living in the long run.

    Investment is a component of aggregate demand. Changes in investment shift the aggregate demand curve and thus change real GDP and the price level in the short run. An increase in investment shifts the aggregate demand curve to the right; a reduction shifts it to the left.

    Components of Investment

    Additions to the stock of private capital are called Gross Private Domestic Investment (GPDI). GPDI includes four categories of investment:

    1. Nonresidential Structures. This category of investment includes the construction of business structures such as private office buildings, warehouses, factories, private hospitals and universities, and other structures in which the production of goods and services takes place. A structure is counted as GPDI only during the period in which it is built. It may be sold several times after being built, but such sales are not counted as investment. Recall that investment is part of GDP, and GDP is the value of production in any period, not total sales.
    2. Nonresidential Equipment and Software. Producers’ equipment includes computers and software, machinery, trucks, cars, and desks, that is, any business equipment that is expected to last more than a year. Equipment and software are counted as investment only in the period in which they are produced.
    3. Residential Investment. This category includes all forms of residential construction, whether apartment houses or single-family homes, as well as residential equipment such as computers and software.
    4. Change in Private Inventories. Private inventories are considered part of the nation’s capital stock, because those inventories are used to produce other goods. All private inventories are capital; additions to private inventories are thus investment. When private inventories fall, that is recorded as negative investment.

    Figure 14.1 “Components of Gross Private Domestic Investment, 1995–2011” shows the components of gross private domestic investment from 1995 through 2011. We see that producers’ equipment and software constitute the largest component of GPDI in the United States. Residential investment was the second largest component of GPDI for most of the period shown but it shrank considerably during the 2007–2009 recession and has yet to recover.

    Figure 14.1 Components of Gross Private Domestic Investment, 1995–2011

    This chart shows the levels of each of the four components of gross private domestic investment from 1995 through 2011. Nonresidential equipment and software is the largest component of GPDI and has shown the most substantial growth over the period.

    Source: Bureau of Economic Analysis, NIPA Table 1.1.6 (revised February 29, 2012).