How Does Investment Affect Productivity & Economic Growth?

Gross domestic product is the economic measure most watched to gauge the economic strength and growth of the nation. It is produced by the U.S. Commerce Department's Bureau of Economic Analysis, which measures four areas of spending to arrive at the GDP: consumer spending, investment, government spending and the total amount of exports net of imports. Investment is the most volatile of the four components and is thought to be the best indicator of the direction of the economy.

There are three components of investment, as used in figuring GDP. They are business spending, new residential construction and changes in inventory. Federal Reserve monetary policy affects investment first because each of the three components relies heavily on bank loans or borrowing via the issue of bonds.

Bank loans and bond issuance creates money in the system, adding to the money supply, which fuels economic growth. When the Fed wants to slow the growth of the economy, it makes borrowing more expensive by raising interest rates and removing money from the system.

Likewise, when the economy is in recession, the Fed lowers rates to encourage borrowing. Low interest rates encourage businesses to invest in new plants and equipment and to increase inventory in anticipation of increased buying by other businesses and consumers. Real estate developers build new housing in anticipation of demand from consumers reacting to low mortgage rates.

Business investment in new facilities, equipment, employment and administrative costs puts money directly into the economy because it uses retained earnings and borrowings from banks and the debt market. When Company A leases, buys or builds new facilities it transfers a large amount of money to another business, Supplier Co., for those facilities. In turn, the new facilities create a need for work hours by Supplier Co. employees, who build, renovate and prepare the new facilities.

The purchase of equipment provides the same boost to the production of Manufacturer Co., and the sales rep who sells the equipment. Company A will hire new employees for its new facilities, just as new employees are being hired by Supplier Co. and Manufacturer Co. to meet the demand from many companies that are investing in their production capacity as the economy begins to move out of recession.

The employees hired by Company A, Supplier Co. and Manufacturer Co. now have money to spend on consumer goods and new housing. New residential construction is part of GDP because of its new use of building materials, appliances and utility hook-ups. Sales of existing houses are not part of GDP, but the money spent by consumers to redecorate falls under the consumer spending component, also called consumption.

The money involved in investment by business in facilities, equipment and employees travels throughout the system – spurring new business investment and new residential building – and even to the other components of GDP, such as consumer spending. It also spurs the import-export trade, as businesses and consumers purchase goods and services manufactured abroad. As business investment creates increased income, governments receive increased revenues from sales taxes and income taxes and spend it on public works and services.

An increase in inventory is the first sign of a move out of recession because companies plan ahead. They invest in additional inventory to meet expected consumer and business demand for products. Investment in inventory by Company A transfers money to Manufacturer Co. and this money enters the import-export trade for the purchase of raw materials. Supplier Co. distributes some of the products of Manufacturer Co., and both companies hire more employees.

Every order of inventory is financed by bank borrowing, which is where the money is created to fuel increased productivity and economic growth.