14.1 The Role and Nature of Investment

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.

Gross and Net Investment

As capital is used, some of it wears out or becomes obsolete; it depreciates (the Commerce Department reports depreciation as “consumption of fixed capital”). Investment adds to the capital stock, and depreciation reduces it. Gross investment minus depreciation is net investment. If gross investment is greater than depreciation in any period, then net investment is positive and the capital stock increases. If gross investment is less than depreciation in any period, then net investment is negative and the capital stock declines.

In the official estimates of total output, gross investment (GPDI) minus depreciation equals net private domestic investment (NPDI). The value for NPDI in any period gives the amount by which the privately held stock of physical capital changed during that period.

Figure 14.2 “Gross Private Domestic Investment, Depreciation, and Net Private Domestic Investment, 1990–2011” reports the real values of GPDI, depreciation, and NPDI from 1990 to 2011. We see that the bulk of GPDI replaces capital that has been depreciated. Notice the sharp reductions in NPDI during the recessions of 1990–1991, 2001, and especially 2007–2009.

The Volatility of Investment

Investment, measured as GPDI, is among the most volatile components of GDP. In percentage terms, year-to-year changes in GPDI are far greater than the year-to-year changes in consumption or government purchases. Net exports are also quite volatile, but they represent a much smaller share of GDP. Figure 14.3 “Changes in Components of Real GDP, 1990–2011” compares annual percentage changes in GPDI, personal consumption, and government purchases. Of course, a dollar change in investment will be a much larger change in percentage terms than a dollar change in consumption, which is the largest component of GDP. But compare investment and government purchases: their shares in GDP are comparable, but investment is clearly more volatile.

Given that the aggregate demand curve shifts by an amount equal to the multiplier times an initial change in investment, the volatility of investment can cause real GDP to fluctuate in the short run. Downturns in investment may trigger recessions.

Investment, Consumption, and Saving

Earlier we used the production possibilities curve to illustrate how choices are made about investment, consumption, and saving. Because such choices are crucial to understanding how investment affects living standards, it will be useful to reexamine them here.

Figure 14.4 “The Choice between Consumption and Investment” shows a production possibilities curve for an economy that can produce two kinds of goods: consumption goods and investment goods. An economy operating at point A on PPC₁ is using its factors of production fully and efficiently. It is producing C_A units of consumption goods and I_A units of investment each period. Suppose that depreciation equals I_A, so that the quantity of investment each period is just sufficient to replace depreciated capital; net investment equals zero. If there is no change in the labor force, in natural resources, or in technology, the production possibilities curve will remain fixed at PPC₁.

Now suppose decision makers in this economy decide to sacrifice the production of some consumption goods in favor of greater investment. The economy moves to point B on PPC₁. Production of consumption goods falls to C_B, and investment rises to I_B. Assuming depreciation remains I_A, net investment is now positive. As the nation’s capital stock increases, the production possibilities curve shifts outward to PPC₂. Once that shift occurs, it will be possible to select a point such as D on the new production possibilities curve. At this point, consumption equals C_D, and investment equals I_D. By sacrificing consumption early on, the society is able to increase both its consumption and investment in the future. That early reduction in consumption requires an increase in saving.

We see that a movement along the production possibilities curve in the direction of the production of more investment goods and fewer consumption goods allows the production of more of both types of goods in the future.

Case in Point: The Reduction of Private Capital in the Depression and in the Great Recession

Wikimedia Commons – public domain.

Net private domestic investment (NPDI) has been negative during only three periods in the last 80 years. During one period, World War II, massive defense spending forced cutbacks in private sector spending. (Recall that government investment is not counted as part of net private domestic investment in the official accounts; production of defense capital thus is not reflected in these figures.) The second period in which NPDI was negative was the Great Depression.

Aggregate demand plunged during the first four years of the Depression. As firms cut their output in response to reductions in demand, their need for capital fell as well. They reduced their capital by holding gross private domestic investment below depreciation beginning in 1931. That produced negative net private domestic investment; it remained negative until 1936 and became negative again in 1938. In all, firms reduced the private capital stock by more than $529.5 billion (in 2007 dollars) during the period.

A third—very brief and very small—encounter with negative net private domestic investment occurred in 2009, when it fell by $1 billion (in 2005 dollars).

The two graphs in this case present a contrast between the Great Depression and the Great Recession. The Great Recession was bad, but the Great Depression was ever so much worse.

Answers to Try It! Problems

1. A new garage would be part of residential construction and thus part of GPDI.
2. Consumer purchases of cars are part of the consumption component of the GDP accounts and thus not part of GPDI.
3. The purchase of a savings bond is an example of a financial investment. Since it is not an addition to the nation’s capital stock, it is not part of GPDI.
4. The construction of a new factory is counted in the nonresidential structures component of GPDI.