EFA (12): Investment

Investment plays a key role in economics. But what exactly is investment? This is the subject of the 12th item in our Economics for Amateurs (EFA) series. You can find this series here every Monday.

Like many words in English, “investment” has different meanings. In everyday usage, it refers to money used to buy financial assets such as bonds or shares, or existing real assets such as an old house or a piece of land. So, someone might say, “I’ve invested most of my money in shares this year” or, “We made a great investment when we bought that 100-year-old house back in 1999”.

In economics, on the other hand, such activities are not counted as investment at all. Instead, they are simply a transfer of savings from one form of asset (cash) to another (bonds, shares, an existing house, etc.).

In economics, “investment” is defined as the sum of money in a given time period (such as a year) that is used to increase or maintain the real capital stock. And the capital stock is the total of all real assets — such as factories, other buildings and machinery — that contribute to the future production of goods and services.

For example, factories produce steel, cars and other goods, while roads enable transport services, and school buildings help to produce educational services. Increases in the levels of inventories and raw materials held by firms are also counted as investment, because they contribute to future consumption.

The construction of new houses is investment, too, because these buildings “produce” housing services for those who live in them. On the other hand, buying an existing house does not count as investment, as it doesn’t add to the capital stock; an existing asset simply changes ownership.

When individuals or firms spend money on new goods such as computers, washing machines and televisions, this is also a form of investment, because these goods are not consumed immediately, but provide services over a number of years.

There is an important distinction to be made for a firm or country between its level of gross investment and its net investment. Gross investment includes both spending on new capital goods and money spent on maintaining the existing capital stock. Net investment is gross investment minus the level of depreciation of existing real assets.

This means that money spent to prevent the condition of a house or factory from getting worse counts as gross investment but not net investment, as it does not add to the capital stock. On the other hand, building an extension to a house — or increasing the size of a factory — counts as both gross and net investment.

The level of net investment in a country is one of the main influences on future economic growth. Typically, countries that are at an early stage of industrialization, such as China, currently spend a much larger share of their gross domestic product (GDP) on net investment than highly-industrialized countries do.

The main factor that determines the level of investment in an economy is the expected rate of return. This depends on technological changes, the level of interest rates (much investment is financed by borrowing) and the expected future level of demand. Psychochological factors — what the British economist John Maynard Keynes called “animal spirits” — also play an important role.