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Did you know that, despite being a much smaller component of real Gross Domestic Product (GDP) than consumer spending, investment spending is often the cause of recessions? According to the Bureau of Economic Analysis, a government agency that collects United States economic statistics, investment spending has not only declined much more than consumer spending on a percentage basis in the last 7 recessions, but it has also declined before consumer spending in the last four recessions. With investment spending being such an important driver of business cycles, it would be wise to learn more. If you are ready to learn more about investment spending, keep scrolling!
So what exactly is investment spending? Let's look first at a simple definition and then a more detailed definition.
Investment spending is business expenditures on plant and equipment plus residential construction plus the change in private inventories.
Investment spending, otherwise known as gross private domestic investment, includes private nonresidential fixed investment, private residential fixed investment, and the change in private inventories.
OK, that's great. But what are all of these components? Have a look at Table 1 below to see the definitions of all of these terms. This will help in our analysis going forth.
|Nonresidential Fixed Investment||Fixed investment in items not for residential use.|
|Structures||Buildings that are constructed at the location where they are used and have long lives. This includes new construction as well as improvements to existing structures.|
|Equipment||Things used in the production of other products.|
|Intellectual Property Products||Intangible fixed assets, used repeatedly or continuously, in the process of production for at least a year.|
|Residential Fixed Investment||Primarily private residential construction.|
|Change in Private Inventories||The change in the physical volume of inventories owned by private businesses, valued at average prices of the period.|
Table 1. Components of investment spending.1
Now that you know the definition of investment spending and its components, let's take a look at some examples.
One example of nonresidential fixed investment is a manufacturing plant, which is included in the structures sub-category.
Another example of nonresidential fixed investment is manufacturing equipment, which is included in the equipment sub-category.
An example of residential fixed investment, of course, is a house.
Finally, stacks of lumber in a warehouse or stockyard are considered inventories. The change in private inventories from one period to the next is included in investment spending, but only the change in private inventories, not the level of private inventories.
The reason that only the change in private inventories is included is that investment spending is part of the calculation of real Gross Domestic Product (GDP) using the expenditures approach; in other words, what is consumed (flow), as opposed to what is produced (stock).
Inventory levels would be tallied using the product approach. If consumption of a certain good is higher than production, then the change in private inventories for the period will be negative. Similarly, if consumption of a certain good is lower than production, then the change in private inventories for the period will be positive. Do this calculation for all goods in the economy and you come up with the total net change in private inventories for the period, which is then included in the calculation of investment spending and real GDP.
An example might help.
Suppose overall production was $20 trillion, while overall consumption* was $21 trillion. In this case, overall consumption was greater than overall production, so the change in private inventories would be -$1 trillion.
* Overall Consumption = C + NRFI + RFI + G + NX
NRFI = Nonresidential Fixed Investment Spending
RFI = Residential Fixed Investment Spending
NX = Net Exports (Exports - Imports)
Real GDP would then be calculated as:
Real GDP = Overall Consumption + Change in Private Inventories = $21 trillion - $1 trillion = $20 trillion
...which would match the product approach, at least in theory. In practice, due to differences in estimation techniques, timing, and data sources, the two approaches don't result in exactly the same estimates of real GDP.
Figure 1 below should help to visualize the composition of Investment Spending (Gross Private Domestic Investment) a little better.
To learn more, check our explanation on - Gross Domestic Product.
Change in private inventories
Economists keep a watchful eye on the change in private inventories. If the change in private inventories is positive, that means that demand is less than supply, which suggests production may decrease in the coming quarters. On the flip side, if the change in private inventories is negative, that means that demand is greater than supply, which suggests production may increase in the coming quarters. In general, however, the streak needs to be quite long or the change needs to be quite large to have any confidence in using the change in private inventories as a guide to future economic growth.
The investment spending multiplier formula is as follows:
MPC = Marginal Propensity to Consume = change in consumption for every $1 change in income
Businesses consume most of their income on things like wages, equipment repairs, new equipment, rents, and new manufacturing plants. The more of their income they consume, the higher is the multiple for the projects in which they invest.
For example, let's say a company invests $10 million to build a new manufacturing plant and its MPC is 0.9. We calculate the multiplier as follows:
Multiplier = 1 / (1 - MPC) = 1 / (1 - 0.9) = 1 / 0.1 = 10
This suggests that if the company invests $10 million to build a new manufacturing plant, the ultimate increase in GDP will be $10 million x 10 = $100 million as the initial investment gets spent by the builder's employees and suppliers, while the resulting income from the project gets spent by the company's employees and suppliers over time.
There are two broad types of investment spending:
Planned investment spending is the amount of money firms plan to invest during the period.
The main drivers of planned investment spending are the interest rate, the expected future level of real GDP, and current production capacity.
Interest rates have the clearest impact on residential construction because they affect monthly mortgage payments and thereby housing affordability and home sales. In addition, interest rates determine project profitability as the return on investment projects must surpass the cost of borrowing to finance those projects (cost of capital). Higher interest rates lead to higher capital costs, which means fewer projects will be undertaken and investment spending will be lower. If interest rates decline, so too will capital costs. This will lead to more projects being undertaken because it will be easier to obtain a return on investment that is higher than the cost of capital. Hence, investment spending will be higher.
If companies expect rapid real GDP growth, they will generally expect rapid sales growth as well, which will lead to increased investment spending. This is why the quarterly real GDP report is so important for business leaders; it gives them an educated guess as to how strong their sales might be in the coming quarters, which helps them to lay out a budget for investment spending.
Higher expected sales lead to higher needed production capacity (maximum production possible based on the number, size, and efficiency of plants and equipment). If current capacity is low, higher expected sales would lead to an increase in investment spending to increase capacity. If, however, current capacity is already high, firms may not increase investment spending even if sales are expected to rise. Firms will only invest in new capacity if sales are expected to catch up to or outpace current capacity.
Before we define unplanned inventory investment, we need two other definitions first.
Inventories are the stocks of goods used to meet future demand.
Inventory investment is the change in overall inventories held by businesses during the period.
Unplanned inventory investment is the inventory investment that was unforeseen compared to what was expected. It can be positive or negative.
If sales are higher than expected, ending inventories will be lower than expected, and unplanned inventory investment will be negative. On the other hand, if sales are lower than expected, ending inventories will be higher than expected, and unplanned inventory investment will be positive.
The firm's actual spending is then:
IA = Actual Investment Spending
IP = Planned Investment Spending
IU = Unplanned Inventory Investment
Let's look at a couple of examples.
Scenario 1 - auto sales are less than expected:
Expected sales = $800,000
Autos produced = $800,000
Actual sales = $700,000
Unexpected leftover inventories (IU) = $100,000
IP = $700,000
IU = $100,000
IA = IP + IU = $700,000 + $100,000 = $800,000
Scenario 2 - auto sales are more than expected:
Expected sales = $800,000
Autos produced = $800,000
Actual sales = $900,000
Unexpected consumed inventories (IU) = -$100,000
IP = $900,000
IU = -$100,000
IA = IP + IU = $900,000 - $100,000 = $800,000
The change in investment spending is simply:
IF = Investment Spending in the first period
IL = Investment Spending in the last period
This equation can be used to calculate quarter-over-quarter changes, year-over-year changes, or changes between any two periods.
As seen in Table 2 below, there was a huge decline in investment spending during the 2007-2009 Great Recession. The change from Q207 to Q309 (the second quarter of 2007 to the third quarter of 2009) is calculated as follows:
IF = $2.713 trillion
IL = $1.868 trillion
Change in Investment Spending = (IL - IF) / IF = ($1.868 trillion - $2.713 trillion) / $2.713 trillion = -31.1%
This was the biggest decline seen in the last six recessions, although it was over a much longer time frame compared to the others. Still, as can be seen in Table 2 below, it is clear that during the last six recessions, investment spending declined every single time, and by rather large amounts. This goes to show how important it is to understand investment spending and to track it, because it is a very good indicator of the strength or weakness of the overall economy and where it may be heading.
|Years of Recession||Measurement Period||Percent Change During Measurement Period|
Table 2. Investment spending declines during recessions between 1980 and 2020.1
In Figure 2 below, you can see that investment spending tracks real GDP fairly closely, although because investment spending is much smaller than real GDP, it is a little hard to see the correlation. Still, generally speaking, when investment spending rises, so does real GDP, and when investment spending falls, so does real GDP. You can also see the large declines in both investment spending and real GDP during the Great Recession of 2007-2009 and the COVID recession of 2020.
Investment spending as a share of real GDP has risen over the last few decades overall, but it is clear in Figure 3 that the increase has not been steady. Large declines can be seen leading up to and during recessions in 1980, 1982, 2001, and 2009. Interestingly, the decline in 2020 was quite small relative to other recessions, likely due to the fact that the recession only lasted two quarters.
From 1980 to 2021, both consumer spending and investment spending increased as a share of real GDP, while government spending's share of real GDP declined and international trade (net exports) became a larger and larger drag on the economy as imports outpaced exports by a growing amount, due in part to soaring imports from China after its inclusion in the World Trade Organization in December 2001.
1. Source: Bureau of Economic Analysis
In the formula for GDP:
GDP = C + I + G + NX
I = Investment Spending
It is defined as business expenditures on plant and equipment plus residential construction plus the change in private inventories.
The difference between spending and investing is that spending is purchasing goods or services to consume while investing is purchasing goods or services to produce other products and services or to improve a business.
We can calculate investment spending in a couple of ways.
First, by rearranging the equation for GDP, we get:
I = GDP - C - G - NX
I = Investment Spending
GDP = Gross Domestic Product
C = Consumer Spending
G = Government Spending
NX = Net Exports (Exports - Imports)
Second, we can approximate investment spending by adding the sub-categories.
I = NRFI + RFI + CI
I = Investment Spending
NRFI = Nonresidential Fixed investment
RFI = Residential Fixed Investment
CI = Change in Private Inventories
It must be noted that this is only an approximation of investment spending due to the methodology used to calculate the sub-categories, which is beyond the scope of this article.
The main factors affecting investment spending are the interest rate, expected real GDP growth, and current production capacity.
There are two types of investment spending: planned investment spending (spending that was intended) and unplanned inventory investment (an unforeseen increase or decrease in inventories due to lower or higher than expected sales, respectively).
Define investment spending
Business expenditures on plant and equipment plus residential construction plus the change in private inventories
What are the three categories of investment spending?
Nonresidential fixed investment, residential fixed investment, and change in private inventories
What are the three sub-categories of nonresidential fixed investment?
Structures, equipment, and intellectual property products
When calculating GDP using the expenditures approach, what aspect of private inventories is included?
The change in private inventories
Which of these is an example of a structure?
A bulldozer would be included in which sub-category of nonresidential fixed investment?
If overall consumption in the economy is higher than overall production, the change in private inventories would be...
If the change in private inventories is large and positive, that suggests production may _____ in the coming quarters.
What is the formula for the investment spending multiplier?
1 / (1 - MPC)
What does MPC stand for?
Marginal Propensity to Change
The two types of investment spending are...
Planned investment spending
The three main determinants of planned investment spending are...
What is the formula for calculating the change in investment spending?
(IL - IF) / IF
IF = investment spending in the first period
IL = investment spending in the last period
Investment spending is a major driver of business cycles.
Over the last few decades, investment spending as a share of GDP has seen a...
In the last four recessions, ______ has declined first.
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