US GDP: How Three Types of Investments Impact Economic Growth
Gross private domestic investment is a critical component of gross domestic product as it provides an indicator of the future productive capacity of the economy. It traditionally amounts to 14% of GDP and is by far the least stable component. In part three of our series exploring GDP we will examine gross private domestic investment which includes three basic types of investment:
1. Non residential investment: Expenditures by firms on capital such as commercial real estate, tools, machinery, and factories.
2. Residential Investment: Expenditures on residential structures and residential equipment that is owned by landlords and rented to tenants.
3. Change in inventories: The change of firm inventories in a given period.
For the benefit of all readers, the following definitions will form the basis of our ongoing discussion. gross private domestic investment is very specifically defined.
Gross: Gross private domestic investment includes the production of all capital goods, including those used to replace depreciated capital.
Private: Moreover, gross private domestic investment measures investment expenditures made by the private sector.
Domestic: And lastly, gross private domestic investment is expenditures on capital goods used in the domestic economy.
In summary, gross private domestic Investment is an aggregate component of expenditures. That aggregate includes Fixed investment the category of capital goods that best reflects what most people consider capital investment. Fixed Investment represents both non-residential and residential expenditures generally totalling 95 to 97 percent of gross private domestic investment.
Change in private inventories makes up the balance of the category. Changes in inventories reflects the business sectors’ stocks of finished products, intermediate goods, raw materials, and other inputs that businesses keep on hand to use in production. Inventories also include final goods that have been produced but remain unsold.
To put some perspective on prior definitions;
GDP = C + I + G + Net Exports
GDP = 15.1 trillion in 2011.
C, personal consumption expenditures totalled $10.7 Trillion in 2011.
Gross private domestic investment was $1.85 trillion or 12.2% of GDP in 2011
Non-residential investment made up $1.48 trillion of the total.
Residential Investment accounted for $338 billion.
Changes in inventory rounded out the category at 36.6 billion
Drilling down through the data beginning with the onset of the Great Recession, non-residential investment is quite frequently ignored as a category of GDP whose expansive bubble burst. As we defined earlier non-residential investment includes commercial real estate.
Commercial real estate's contribution to GDP went from $583.6 billion in 2008 to $409.5 billion in 2011. This represented a decline from 3.8% to 2.7% of GDP. In addition, by 2011 residential real estate accounted for only $337 billion in expenditures.
Combined construction contributed in real dollars (including both commercial and residential) was $1.195 trillion or 8.9% of GDP, in 2006. By 2011 that total had dropped to $746.5 billion, 4.9% of GDP. In half a decade, our decrease in Gross Domestic Private Investment reduced the nation’s GDP by an entire 4%!
In 2006-2007 prior to the onset of the Great Recession, gross private domestic investment was 16% of the GDP. It dipped to a low of 11% in 2009 and finished 2011 at 12.6% of GDP.
There is a growing minority among the business and academic community calling on a focus to increase gross private domestic investment as the key to unlock the recovery and lower unemployment. Stimulating gross private domestic investment does hold promise in expanding the recovery yet there are risks involved.
Adding capacity to produce new equipment and software can and will create jobs. What cannot be forgotten is new plants, equipment and software will increase efficiency reducing the need for labor per unit of output. As example total factor productivity has risen 3.2% in each of the last 2 years, the highest rate since the Bureau of Labor Statistics started keeping tabs in 1987. We can produce the same output today with 7% less labor than two years ago.
Yet no matter the risks, in the long-run investment in new plant, new and better products, and new methods of production is a tenant of economic growth. You do not need to hold a PhD in economics to realize, addressing policy which facilitates gross private domestic investment offers a realistic opportunity to enhance the recovery while positioning the nation for future growth.
While the process of understanding how the components which make up GDP is time consuming, I hope you have found this essay enlightening. Please consider joining us for part four of this series on GDP when we explore government expenditures.