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Investment, expenditure of wealth to enable future production or other advantageous economic yield. What constitutes “investment” depends on the economic “agent” in question. For an individual or a household, the investment might comprise mainly the purchase of financial assets (stocks or bonds), as well as the purchase of durable goods, notably dwellings, cars, and so on. But for the economy as a whole (leaving aside international transactions), most of this will not count as investment. To begin with, the total wealth of a nation cannot be increased by an increase in a number of financial assets held by its citizens, since these merely represent claims against other citizens and hence appear as liabilities on the balance sheets of other citizens. Purchases and sales of financial assets merely reflect changes in the claims on existing assets (or on the income produced from them). For similar reasons, purchases of second-hand items of capital equipment are not included in investment for an economy as a whole. This is because their purchase or sale does not constitute any net addition to national income (apart from adding to dealers’ commissions) since they, too, represent merely the change in ownership of existing assets, and their production would have been counted once already in the national output and income of the year when they were produced.

Furthermore, according to the national accounting conventions adopted by almost all countries in the world, private households’ purchases of consumer durables, such as cars or TV sets, are not included in investment at any time, but are treated as “private consumption”. This is because, by convention and largely for reasons of statistical convenience and feasibility, it is assumed that the services derived by private households from such durable goods do not add to the national product or national income. Likewise, a car purchased by the government is not included in estimates of investment.

For the economy as a whole, investment—or “gross capital formation” in national accounting parlance—is an addition to its stock of real capital, notably its stock of productive capital in the form of factories, machinery, transport equipment, and so on, as well as human capital in the form of a skilled and educated labour force. If changes in stocks (inventories) are excluded, the relevant concept is gross fixed capital formation. If allowance is made for depreciation (more exactly for “capital consumption”) the net addition to the economy’s stock of productive capital is known as “net capital formation”. Thus, unlike, for example, a car purchased by a private individual, an item of transport equipment purchased by a company would be included as an investment, since this is regarded as adding to the community’s productive capital. One major anomaly is that the purchase of newly produced private dwellings is included in the conventional definition of gross capital formation, although the services obtained from such dwellings are not usually included in estimates of national income.

Insofar as the national capital includes its human capital, it is arguable that investment in human capital should be taken into account. This would mean that a part of education should be included in investment, rather than be treated as consumption (by private household or the state).

What determines the level of investment is still a highly contentious topic in economics. Various main approaches have been adopted. One approach—the “accelerator theory”—has been to link annual investment to the changes required in the economy’s capital stock resulting from changes in annual output. This theory, when linked to other assumptions, plays a major role in certain theories of business cycles. Another approach—the “neoclassical theory of investment”—focuses on the determination of the equilibrium capital stock in terms of variables such as the level of activity, the price of output, the cost of capital goods, and the “opportunity cost” of capital (reflecting mainly the interest rate that could be earned by investing in a financial asset). Investment is thus determined by the desire to eliminate any divergence between the actual capital stock and the desired capital stock for any given value of the variables determining the latter. Many ingenious attempts have been made to estimate these relationships and the “production function” underlying them, but such attempts are fraught with immense econometric difficulties. Some of these reflect the fact that accurate observations of the “capital stock” itself are not available and the extent to which the investment in any time period, say a year, reflects the attempt to reach the desired level depends on the speed of adjustment. Insofar as the determining variables are constantly changing and insofar as much investment may have a long gestation period over several years (for example, a power station or a “green field” site factory), the interpretation of past changes in investment and its related variables is obviously an extremely complex matter. Other approaches would put great emphasis on the buoyancy of company expectations and on the role of uncertainty in determining investment, or the liquidity position of companies, and so on. These different theories are not necessarily all mutually exclusive. Since firms can vary the precise timing of their investment, as well as its volume, much will depend on the time period in question and the precise circumstances.

Contributed By:
Wilfred Beckerman