Investment is a central factor in determining the gross domestic product, which is the aggregate measure of a country's economic output. As societies invest more, they increase their capacity to produce more goods and services at lower costs, meaning greater productivity and economic growth. Investment, in short, drives increases in productivity and growth.
Economists define investment as spending on inventories, structures and capital, defined as equipment used for producing goods and services. Manufacturing firms, for example, invest when they purchase an additional facility or new machinery for producing their products. Investment in structures includes household purchases of new homes.
Effects on Productivity
Productivity refers to the amount of products and services produced for each hour of labor. Investment fuels rises in productivity by increasing the productive capacity of workers and firms. Investment in labor-saving machinery, for example, can save labor hours, producing more products in less time. This reduces production costs by saving on labor, one of the largest costs in the production of a product, notes Harvard economist Greg Mankiw, a former White House adviser.
Effects on Economic Growth
Because investment is a component of GDP, increasing investment can fuel economic growth as measured by annual increases in GDP. In his textbook, "Principles of Economics," Mankiw presented investment and economic growth rate data for 15 countries over a 31-year period, spanning 1960 to 1991. Countries with higher rates of investment, such as Japan, South Korea and Singapore, had the highest economic growth rates for that period. These results indicate a positive correlation between investment and economic growth.
Economics is all about the allocation of scarce resources, investment resources. Mankiw cautions that increasing investment means that societies must spend less and save more. A higher savings rate means the banking and financial system has more resources to lend, enabling companies to accumulate more capital for greater productivity and growth. Sacrificing present consumption frees more money for investment, enabling tomorrow's consumers to enjoy more consumption in the future, Mankiw writes.