How Does Total Capital Investment Influence Economic Growth?

In general, economic growth occurs as a result of increases in the production of goods and services. Increased consumer spending, increased international trade, and businesses that increase their investment in capital spending can all impact the level of production of goods and services in an economy.

For example, as consumers buy more homes, home construction and contractors see increases in revenue. As companies invest in their businesses in order to expand their products and services, they hire more employees and increase salaries or wages. All of this activity leads to economic growth, which can be measured by gross domestic product (GDP)—the total monetary or market value of all the finished goods and services produced within a country's borders in a given period.

Economic Growth Can Be Measured By Gross Domestic Product (GDP)

In the United States, for example, the government releases an annualized GDP estimate for each quarter and also for an entire year. As a broad measure of overall domestic production, GDP functions as a comprehensive scorecard of a country’s economic health and its relative growth.

Key Takeaways

  • Capital investment refers to a company's acquisition of assets such as real estate, manufacturing plants, machinery, computers, vehicles, and production equipment.
  • Economic growth can be measured by gross domestic product (GDP)–the total monetary or market value of all the finished goods and services produced within a country's borders in a given period.
  • In the U.S., economic growth is primarily driven by consumer spending and capital investment.
  • Capital investment can be the differentiating factor in whether or not an economy experiences a healthy growth rate or an anemic growth rate.

Periods of high economic growth have occurred throughout history; they are usually prompted by discoveries of new natural resources or the invention of new technology. For example, the invention of the Internet in the 1980s paved the way for the invention of many other new technologies, including e-commerce, which revolutionized the way most firms conduct business. In the U.S., in the early 2000s, vast reserves of shale oil were discovered. This discovery led to the U.S. becoming the world's largest crude-oil producer.

Without capital investment, innovation is not possible, including the discovery of new reserves of natural resources or technological advances. Capital investment occurs when businesses purchase capital goods, which are tangible assets such as buildings, machinery, equipment, vehicles, and tools. These tangible assets are then used to produce goods or services. Capital investment is a means for a company to further its business objectives.

Capital Investment's Relationship to Gross Domestic Product (GDP)

In order for it to be economically viable for a business to increase or improve its capital structure, a company must have adequate cash or funding. Typically, a business would seek this funding through issuing debt–or bonds–or equity–by issuing stocks.

Capital investments are long-term investments; they allow companies to generate revenue for many years by adding or improving production facilities and boosting operational efficiency. A business does not see an immediate increase in revenue when it makes investments in capital goods.

An increase in capital investment allows for more research and development in the capital structure. If a company wants to take new products and services to the market, they will typically engage in research and development activities as their first step towards innovating and introducing new products and services or improving their existing offerings.

Additional or improved capital goods is intended to increase labor productivity by making companies more productive and efficient. Newer equipment or factories leads to more products being produced, and at a faster rate. For example, a new production facility might use less electricity because it uses newer equipment and is housed in a more energy-efficient building. As a result, more products can be produced at a lower cost, and with faster turnaround times; this can increase the company's profits.

As labor becomes more efficient, this increased efficiency nationwide leads to economic growth for the entire country and a higher nationwide GDP.

Capital goods are not the same as financial capital or human capital. Financial capital includes the funds necessary to sustain and grow a business, which a company secures by issuing either debt–in the form of bonds–or equity–in the form of shares. Human capital refers to human labor or workers. Before a company can invest in capital goods, it must first have the resources and infrastructure set up to secure financial capital. Human capital is then used to design, build, and operate capital goods.

Example of Capital Investment and Economic Growth

The table below shows the percentage of yearly GDP growth from 2016 to 2018 according to the Bureau of Economic Analysis (BEA). The table shows the annual GDP growth rate for each year, as well as what factors contributed to that growth. As you can see from the table, the annual GDP growth rate was 1.6% for 2016 and 2.9% for 2018. Personal spending or expenditures (indicated by the color green) was 1.85% in 2016 and 1.80% in 2018. So, consumer spending between 2016 and 2018 was approximately the same. However, capital spending or private business investment (indicated by the color red) was -.24% in 2016 and 1.02% in 2018.

In other words, business investment through purchases of capital goods drove GDP higher in 2018—comprising 1% of the total 2.9% GDP for the year. The table also breaks it down even further, revealing that structures and equipment purchases were higher in 2018 versus 2016.

Please note: The table above is a truncated version, meaning there were other smaller contributors to growth that are not included. Image by Sabrina Jiang © Investopedia 2020 

This data reveals that U.S. economic growth was predominately driven by consumer spending and capital investment spending in the years 2016 and 2018. Given that consumer spending was nearly the same in 2016 and 2018, it can be assumed that the extra GDP growth in 2018 was mostly due to a higher level of capital investment. In the U.S., there were more purchases of capital goods in 2018, including industrial equipment, transportation, software, and structures, such as buildings or factories. Therefore, capital investment can make a significant impact on economic growth.