Jon has taught Economics and Finance and has an MBA in Finance
Discover the important difference between investment in economics and investments that individuals make by saving out of their income. This lesson defines and outlines the basic components of gross private domestic investment.
All right, we need to spend a little time talking about the word 'investment,' and we need to make a very important distinction. Just imagine this:
One of your neighbors (we'll call him Bob) owns a well-known lawn-cutting business. Bob cuts lawns all day long, especially during the summer months, of course. When he earns income from his business, he takes some of that income and decides to invest some of it into the stock market, buying 500 shares of Felix Homemade Ice Cream Stores. Let's say that this year was extremely profitable for Bob, and he notices that the demand for lawn-cutting services is increasing. Early in the year, he had 50 customers, but suddenly, 25 additional customers have just signed agreements for lawn-cutting services with Bob.
When Bob had 50 lawns, he was able to cut them all by himself using one mower throughout the week and just going from lawn to lawn. However, with 25 new customers and a full schedule of mowing already, that means that Bob's going to have to expand his lawn service in order to increase the supply of lawn cuts so he can meet rising demand. How does Bob expand? By investing into his business, which will end up flowing through the economy. For example, he invests by purchasing another lawn mower and also by hiring a worker.
Time-out. I want you to notice that I used the same word, 'invest,' to describe both of these two events. When Bob saved some of his income and purchased a stock, he called it investing. When he wanted to expand his business, though, he might describe it as 'buying more equipment' or 'expanding,' but economists call that investment. Understanding the difference between these two things is necessary to understand economics.
When we hear the word investment in economics, it refers to gross private domestic investment, and it's not referring to investments that most of us are familiar with, such as our 401-Ks or mutual funds. Investment is the value of all goods produced during a period for use in the production of other goods and services. So, all the things that go into the production process for consumer goods, such as the manufacturing equipment at a product factory, or buildings that house businesses along with the equipment that businesses use to supply goods and services to consumers. In the case of a service business, like Bob's lawn service, the purchase of additional mowers, as well as hiring a worker, were purchases that were made in order to provide the service of lawn mowing. These are considered investment.
We often hear and use the word investment in society, but most people are not referring to gross domestic private investment. When we say we purchased an investment in a large company stock, we're talking about a financial investment of money that either earns interest or has the potential to increase in value. Economists, on the other hand, use the term 'investment' to describe all the activities that lead to capital investments within an economy. They call the financial investments 'savings.'
Ingredients of Investment
Let's talk about the three main ingredients inside the investment component of our GDP:
The first category is business expenditures. When Bob's low-rider mowing service buys a new lawn mower today, this is considered an investment and is counted in our GDP for this year.
The second category is new residential housing. When Bob's business takes off, he decides to use some of his profit to build a new house. Once his house is constructed, this is now included in the investment component of our GDP.
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Finally, changes to the inventories of businesses across the country are considered investment in the year in which products are produced. For example, let's say that, in addition to lawn cutting, Bob happens to also sell fertilizer bags to consumers who are interested. Bob keeps an inventory of fertilizer bags in a small warehouse, and from time to time, he buys more bags to make sure he has enough to offer for sale to his customers. Whenever Bob orders new bags to place in his inventory, the new bags are counted as investment, which gets counted in the GDP for the current year. However, when the bags are sold to customers, they are counted as consumption in the year they are purchased, while an adjustment is also made subtracting them from inventory at the same time. This enables economists to count the production of goods, even though we don't know when they will be sold.
Savings and Investment
Let's talk about the direct connection between savings and investment because this is very important; it makes the economy grow over the long term. In order to invest in the economy, money must be saved. Therefore, there is a direct connection between the amount of savings and the amount of investment in a nation.
For example, when Bob saves some of his income from mowing lawns, he deposits it into a savings account at his local bank. The bank then takes his savings and loans out most of it to an entrepreneur, Mandy, who needs to expand her canned soup business. Bob's savings created the opportunity for Mandy to borrow money and make an investment, which is also an investment into our economy. Savings is directly connected to investment. That's why economists are concerned with the savings rate of a nation.
In addition, for Bob to save some of his income, he had to choose not to spend some of this income. Savings reduces consumption today but leads to investment and, therefore, future growth in the economy.
Let's summarize what we've talked about in this lesson. Investment, otherwise known as Gross Domestic Private Investment, is the value of all goods produced during a period for use in the production of other goods and services. When economists use the word 'investment,' they're not referring to financial investments such as 401-K's and stock or bonds purchases. They are referring to business activities within the economy that lead to the production of other goods and services.
The three main ingredients in investment of our GDP include:
New residential homes constructed
Changes in business inventories
Savings is directly connected to investment in an economy. Investment today requires savings today, but investment produces economic growth that leads to future consumption.
Once you finish this lesson you'll understand the components that make up investment in Gross Domestic Product calculation and its differences with financial investments.
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