Gross domestic private investment represents investment spending by the private sector. This is one component of gross domestic product (GDP) in addition to household consumption, government spending, and net exports.
Investment growth contributes to increasing the productive capacity of the economy (and potential GDP). Increased investment shifts the aggregate demand curve to the right and stimulates higher real GDP. When investment increases, the stock of capital goods – such as machinery and factories – increases. That ultimately led to a rise in production.
Investment component
Private gross domestic investment consists of two main categories: gross investment and changes in inventories. The gross investment consists of buying residential and non-residential investment and replacing capital using (depreciation). The latter also called capital consumption allowance.
Let’s break down the components one by one.
- Non-residential investment includes the purchase of capital goods such as equipment, trucks, cars, computers and software, machinery, and factories.
- Residential investment consists of purchasing new residential properties, such as apartments and landed houses.
- Changes in inventory refer to changes in the company’s stock in a certain period. Inventories include semi-finished goods, raw materials, and other inputs. Businesses use them for further production processes. This component also consists of the final item before it is sold to the market. Usually, the change inventory is relatively small and very volatile.
Three determinants of gross private domestic investment
- Interest rate. Higher interest rates make investment costs more expensive. When interest is higher, businesses tend to be reluctant to spend their money to buy capital goods unless it results in higher investment returns. Conversely, when interest rates are lower, the cost of investment funds is also fall, encouraging businesses to buy new equipment.
- Price expectations in the future. If companies expect their output prices to increase relatively high compared to the general price level (inflation), they will increase production in anticipation of higher profit margins. They decided to buy new equipment to increase their production capacity. This situation usually occurs when demand is high or during economic expansion.
- Capacity utilization. If companies operate near full capacity (capacity utilization rate of almost 100%), they need to increase investment spending to expand capacity further.
Effects on economic cycles
Gross private domestic investment is the most volatile component of GDP. Its change is usually associated with fluctuations in the economic cycle. Changes in capital expenditure, especially spending on inventories, are among the main factors causing short-term economic fluctuations.
Business perceptions about the future direction of the economy affect changes in inventories. If the company believes that demand for their products increases, they will quickly increase purchases of raw materials and increase inventory. On the other hand, if they think that economic activity will decline, they will liquidate supplies immediately.
