Investment Spending

Investment Spending: Definition

So what exactly is investment spending? Let's look first at a simple definition and then a more detailed definition.

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.

Table 1. Components of investment spending.¹

Investment Spending: Examples

Now that you know the definition of investment spending and its components, let's take a look at some examples.

Nonresidential Fixed Investment

One example of nonresidential fixed investment is a manufacturing plant, which is included in the 'structures' sub-category.

Fig. 1 - Manufacturing Plant

Another example of nonresidential fixed investment is manufacturing equipment, which is included in the 'equipment' sub-category.

Fig. 2 - Manufacturing Equipment

Residential Fixed Investment

An example of a residential fixed investment, of course, is a house.

Fig. 3 - House

Investment Spending: Change in Private Inventories

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.

Fig. 4 - Lumber 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, the change in private inventories for the period will be negative. Similarly, if the consumption of a certain good is lower than production, 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:

Figure 5 below should help to visualize the composition of Investment Spending (Gross Private Domestic Investment) a little better.

Figure 1. Composition of Investment Spending - StudySmarter. Source: Bureau of Economic Analysis¹

Investment Spending Multiplier Formula

The investment spending multiplier formula is as follows:

$Multiplier=\frac{1}{(1-MPC)}$

Where:

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 the multiple of projects in which they invest.

Determinants of Investment Spending

There are two broad types of investment spending:

• Planned investment spending.
• Unplanned inventory investment.

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.

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:

$I_A=I_P+I_U$

Where:

I_A = Actual Investment Spending

I_P = Planned Investment Spending

I_U = Unplanned Inventory Investment

Let's look at a couple of examples.

Change in Investment Spending

The change in investment spending is simply:

$Changeininvestmentspending=\frac{(I_L-I_F)}{I_F}$

Where:

I_F = Investment Spending in the first period.

I_L = 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.

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 you can see in Table 2, 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.

Table 2. Investment spending declines during recessions between 1980 and 2020.

In Figure 6 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 2007–09 and the COVID recession of 2020.

Fig. 6 - U.S. Real GDP and Investment Spending. Source: Bureau of Economic Analysis

Investment spending as a share of real GDP has risen over the last few decades overall, but it is clear in Figure 7 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. 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.

Fig. 7 - U.S. Investment Spending Share of Real GDP. Source: Bureau of Economic Analysis