Investment Times Three

• Investment: This is the generic term for the sacrifice of current consumption to enhance future production capabilities. Such investment can involve the business acquisition of capital goods or activities undertaken by the household sector, such as attending college. Investment is the fundamental means of achieving economic growth.


• Investment Expenditures: This is the more specific term referring to actual expenditures on goods and services, or gross domestic product, by the business sector. Investment expenditures specifically deal with investment activities that involve business purchases of capital goods. Not all generic investment activities involve investment expenditures on gross domestic product.


• Gross Private Domestic Investment: This is the official measure of the investment expenditures component of aggregate expenditures used in the calculation of gross domestic product.

Business Cycles

The total amount of expenditures undertaken by the business sector on gross domestic product is critical to business-cycle activity. Should the business sector decide to spend more or less on capital goods, then the macroeconomy can experience business-cycle expansions and contractions.

Suppose, for example, that profit-seeking firms of the business sector become increasingly optimistic about the state of the economy. They expect the economic future to be bright, rosy, prosperous, and profitable. As such, they increase investment spending on factories, buildings, equipment, and machinery. The result of this additional spending is a short-run business-cycle expansion.

However, should the business sector, in mass, become increasingly pessimistic about the future of the economy, then they are inclined to decrease investment expenditures. This reduction will likely trigger a short-run business-cycle contraction.

Because investment expenditures tend to be volatile, they are a major source of business-cycle instability.

Economic Growth

Capital goods are key to the productive capabilities of the economy. An increase in the quantity of capital, expands the ability to produce goods and thus results in economic growth. A decrease in the quantity of capital, diminishes this production capacity.

An increase in the production of capital goods inevitably corresponds with a decrease in the production of consumer goods purchased by household sector consumption expenditures. This tradeoff between consumption and investment is fundamental to the process of long-run economic growth. By devoting more resources to investment and less to consumption today, an economy generates greater economic growth in the future. By devoting more resources to consumption and less to investment, economic growth can be less or even negative.

A Variety of Expenditures

• Nonresidential Fixed Investment: This includes expenditures on what is most commonly thought of as capital goods, such as factories and machinery. Examples include buildings, pipelines, oil wells, computers, and vehicles. It constitutes about 70 percent of investment expenditures.


• Residential Fixed Investment: This includes expenditures on houses, apartments buildings, and similar types of shelter. Residential fixed investment includes structures built, owned, and occupied by individuals as well as those run by profit-minded businesses. Residential fixed investment is typically just under 30 percent of investment expenditures.


• Changes in Private Inventories: Inventories are stockpiles of raw materials, intermediate goods, and finished products that businesses use to smooth the flow of production and sales. Businesses typically make planned investments in their inventories, such as when a new retail store is opened. However, in some cases unplanned changes in business inventories arise due to a mismatch between production and sales. Changes in private inventories, whether planned or not, are usually in the range of 2 to 5 percent of investment expenditures.

The Circular Flow

The Circular Flow

A basic representation of the circular flow is displayed to the right. The components of this model are the four macroeconomic sectors--household, business, government and foreign--and the three macroeconomic markets--product, resource, and financial.

The household sector at the far left contains the consuming population of the economy. The business sector at the far right includes all of the producers. The government sector is positioned in the middle of the diagram and the foreign sector is at the very top.

The product markets near the top of the flow direct production from the business sector to the household sector in exchange for payment flowing in the opposite direction. The resource markets at the bottom of the flow direct factor services from the household sector to the business sector in exchange for payment flowing in the opposite direction. The financial markets located just above the resource markets divert saving from the household sector to business and government borrowing.

The circular flow indicates that the income used by the household sector to purchase goods through the product markets is obtained by selling factor services through the resource markets. It also indicates that the revenue used by the business sector to pay for factor services obtained through the resource markets is generated by selling goods through the product markets.

Investment expenditures are the flow between the business sector and the product markets. In particular, the business sector makes investment expenditures to purchase a portion of gross domestic product through the product markets. The business sector pays for these purchases with income received from selling legal claims to the household sector through the financial markets.

Determinants

The causes of such changes are termed investment determinants. Here are a few of the more important ones:

• Interest rates are a key determinant of investment expenditures. Investment is usually financed with borrowed funds. If interest rates change, then the cost of borrowing changes and so too does the overall cost of the investment. A higher interest rate means fewer investment expenditures.


• Physical wealth is a second important influence on investment expenditures. For investment, the key type of physical wealth is capital, the object of investment. The business sector is less inclined to invest in capital goods, if it has undertaken a lot of investment recently. A boost in capital is bound to cause a decline in investment expenditures.


• Expectations are a third influence that determines the amount of investment expenditures. If the business sector sees an improving economy on the horizon, with expectations of greater sales and profits, they are more inclined to expand investment now, in spite of current conditions. This, of course, boosts investment expenditures.


• Capital prices are also critical to investment expenditures. Invoking the basic law of demand, if the price of capital increases, the business sector decreases the quantity of capital demanded. That generates a decrease in investment expenditures.


• Technological advances enhance the need to invest in capital. A new technology needs new capital, different capital, capital to implement the technology. Technological advances invariably trigger an increase in investment expenditures.

Three More Expenditures

• Consumption Expenditures: Consumption expenditures are the expenditures by the household sector on final goods and services undertaken in a given time period. The official measure of consumption expenditures is termed personal consumption expenditures and is generally divided into three categories--durable goods, nondurable goods, and services. Consumption expenditures are the largest and most stable of the four expenditures. They are about 60 percent to 70 percent of aggregate expenditures. They play a critical role in the macroeconomy.


• Government Purchases: Government purchases are the expenditures by the government sector on final goods and services undertaken in a given time period. The official measure of government purchases is termed government consumption expenditures and gross investment, which reflects the fact the some government purchases are for consumption goods and some for capital investment. They are also about 10 percent to 15 percent of aggregate expenditures. Government purchases are a key fiscal policy for addressing business-cycle instability.


• Net Exports: Net exports are the difference between exports (goods and services produced by the domestic economy and purchased by the foreign sector) and imports (goods and services produced by the foreign sector and purchased by the domestic economy). The official measure of net exports is simply termed net exports of goods and services. The two components of net exports are exports from the domestic economy to the foreign sector and imports from the foreign sector to the domestic economy. They are typically about 2 percent of aggregate expenditures. Net exports play a relatively small role in the macroeconomy.

AE = C + I + G + (X-M)