Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Investment

To the non-economist, an investment is buying something in the hope that it will increase in value over time and/or yield some kind of income. For example, buying a Victorian terraced house can be considered an investment: you hope that it rises in value and earns you a decent rental income. Similarly, buying shares is an investment: you hope that they go up in price and that you get some healthy dividends along the way.

To economists, however, neither of these counts as investment. Instead, an investment is buying something new that can be used to produce something in the future. Examples of investment include a firm building a new factory, buying a new machine or even buying some new computers. All these things help it to produce goods and services, which it can then sell to consumers.


An individual buying a house isn’t considered a form of investment by economists, except in the case of buying a newly built house. This is because you can think about a new house as ‘providing housing services’ in the future. This approach may sound like a strange way of thinking about this situation, but it makes clear why buying an already existing house from someone doesn’t count as investment: it doesn’t create any new ‘housing services’. Instead you’ve just transferred the right to existing housing services from someone else to yourself.

Similarly, a firm buying a machine second-hand from another firm doesn’t count as investment, because the total number of machines hasn’t increased.

Capital

If you hear an entrepreneur complaining that he doesn’t have enough capital,

he probably means that he needs more money to get his business off the ground.


When economists talk about capital, they (usually) mean capital stock. This is all the machines, offices, computers and so on that are used to produce goods and services.


Investment and capital stock are closely linked. Investment is the purchase of new capital goods (goods that can be used to produce other goods and services). Thus, the capital stock, as its name suggests, is a stock variable, and investment is the yearly addition to the capital stock, so it’s a flow variable (see the preceding section).

Does this mean that the capital stock in a country can only ever rise? Well, no. Every year machines and other capital goods get worn down (they depreciate). In order for the capital stock to rise, investment that year has to be more than the depreciation of the existing capital stock.

Economists often use mathematical equations in order to express ideas concisely, and you can express the relationship between investment and capital as follows:

In words, this equation says that the capital stock tomorrow (K_{t +1}) is equal to the capital stock today (K_t), less depreciation ( , proportion of the capital stock depreciates) plus investment today (I_t, which is just the new capital purchased today).