Gross domestic product (GDP) is one of the most important economic indicators used to measure the health of an economy. It represents the total value of all final goods and services produced within a country over a specific period of time. GDP can be calculated using three approaches – the expenditure approach, the income approach and the production approach.
The expenditure approach sums up all expenditures made on final goods and services in an economy. This includes consumer spending, business investments, government spending and net exports (exports minus imports). The income approach sums up all incomes earned by the factors of production within an economy, including wages, rents, interest and profits. The production approach sums up the value added at each stage of production.
One important component of GDP in the expenditure approach is gross domestic investment, which includes investments in fixed assets like buildings, machinery and equipment as well as investments in inventories. The concept of net domestic investment refers specifically to the net additions to the capital stock after accounting for depreciation, which is the using up of fixed capital over time. In other words, net domestic investment is the portion of gross investment that actually contributes to increasing the economy’s capital stock. It is an important driver of economic growth.
Gross domestic investment contributes to GDP growth
Gross domestic investment, or gross capital formation, includes expenditures on fixed assets like factories, machinery, equipment, and expenditures on inventories. It is a major component of aggregate expenditures and constitutes an injection into the circular flow of income. By investing in new buildings, equipment and technology, firms can expand their production capabilities. Investments in inventories also allow firms to meet rising demand. Therefore, higher investment spending directly contributes to GDP growth in the short run. Over the long run, investments add to the economy’s capital stock and productive capacity, improving productivity and enabling stronger GDP growth.
Depreciation must be accounted for to determine net investment
However, not all investment expenditure contributes to expanding the capital stock. Some investment goes towards replacing capital that is wearing out or becoming obsolete, a process known as depreciation. Net domestic investment specifically refers to the net additions to the capital stock after accounting for depreciation. It is calculated as gross investment minus depreciation on fixed capital. Only net investment directly increases the economy’s stock of productive capital. From 2010-2020, gross private domestic investment in the United States averaged around $3 trillion annually, while consumption of fixed capital averaged around $2 trillion. Therefore, net domestic investment averaged around $1 trillion per year.
Net domestic investment drives increases in future productive capacity
Net domestic investment is a critical driver of economic growth because it directly expands the economy’s future productive capacity. When firms invest in new equipment, buildings, technology and research, it allows them to produce more goods and services in the future. A higher capital stock boosts productivity and enables the economy to grow faster. On the other hand, when investment falls short of depreciation, the capital stock shrinks over time, reducing productive capacity and weighing on future economic growth. Tracking net domestic investment rather than just gross investment provides a better picture of how investment is affecting the economy’s productive capacity and long-run growth potential.
In summary, the concept of net domestic investment refers specifically to the additions to the capital stock of an economy after accounting for capital depreciation. By directly expanding an economy’s productive capacity, net domestic investment is a key driver of GDP growth over the long run.