How does investing promote financial growth? The simple answer is that investments, whether indirect or direct investments, positively correlate with the rate of economic growth. This relation is because private-sector spending and public investments are components of aggregate demand (AD) and directly affect the overall productive capacity; expenditure on capital spending leads to development as governments and the public fund projects, equipment, resources, and more. Increased productive capacities of countries, in turn, influence their Long Run Aggregate Supply (LRAS).

What Factors Influence Economic Growth?

The real Gross Domestic Product (GDP) or Gross National Product (GNP) defines a country’s financial growth. GDP and GNP are broad measures used to aggregate the total economic output within a country’s borders; as more goods and services are provided, there is an increase in output, leading to growth in financial markets. Furthermore, growth in one country is interlinked with others, as regions’ events and economic activity have dynamic effects on economic development or economic recession of other regions. What factors influence economic growth? Below is a summarized list of a few factors:

1.  Human Capital

Human capital is the sum of the capital investments that improve the quality of the labor force. Increased investment in human capital results in several positive effects on abilities, skills, and training. Spending on education, for example, can lead to more educated and trained professionals that limit inefficiencies and encourage faster output growth. A competent engineer will be able to design better equipment; trained factory workers will be able to operate equipment better, and a capable manager would deliver a well-organized project. All of these are the effects of increased investment in education.

2.  Natural Resources

The availability of natural resources in a region indeed affects the economy. However, the discovery and successful utilization of these resources matter more for tangible and measurable long-term economic growth. Mining mineral deposits and oil efficiently has been beneficial for the economies of several countries, Saudi Arabia being a prime example.

3.  Physical Capital

Federal spending on the infrastructure of a region can improve the roads, factories, vehicles, and machinery of the area, thus reducing the cost of economic activity. Increased physical capital leads to increased productivity and output. Better machinery and tools increase the production capabilities of industries, leading to more efficient production of products. Better roads and vehicles allow for more convenient transport of raw materials and produced goods around the region, increasing the region’s GDP. The increased economic capacity of the area will also reduce the unemployment rate in it. This wide range of benefits is possible through increased physical capital.

4.  Technology

Technology is another factor that affects financial growth. A rise in investment into research and development will result in better technology which accelerates productive capacity, leading to sustained long-term growth. The invention of the Internet is an excellent example of how technology influences economic growth. In the 1980s, the invention of the Internet snowballed an array of technological advances, for example, e-commerce. This growth improved the private sector significantly.

5.  Entrepreneurship

Private-sector investments and encouragement for entrepreneurs to bring forth innovations and visions that revolutionize processes and revitalize private-sector productivity can benefit the host country’s economy. Better private markets result in more consumer spending and superior goods and services.

Why is Capital Important for Economic Growth?

Although other factors, like the laws, regulations, fiscal policy, population, and others, influence economic growth, investment in the factors mentioned earlier leads to stable financial markets and growth. For these factors, a rise in investment leads to additional growth in the output and economy of an area. Technological advances, development of the education sector and private sector, private-sector productivity, social security spending, increased human capital, and more lead to multifactor productivity, leading to stable financial markets and long-term growth.

The aggregate spending on these sectors improves the capital structure of companies and industries, allowing them to provide better goods and services and improving the overall standards of living. Spending on health will lead to better health care, and citizens will generally be healthier; military spending will improve the defense sector; a rise in government spending will lead to better infrastructure; the list goes on.

Capital investments do not necessarily lead to an immediate rise in revenue for companies. They fund private firms to improve their facilities and operational efficiency. Before companies introduce new products and offerings to the general public, they engage in research and development activities to ensure commercial success through another project or product launch. This process leads to an economy’s higher productivity and productive capacity, both of which boost the long-run aggregate supply (LRAS). Increments in LRAS is fundamental for sustainable economic growth since it ensures that financial markets will improve without inflation.

Improvements in capital goods or the introduction of new goods through capital spending aim to increase labor productivity. As processes and machinery are safer and more convenient, products can be manufactured at faster rates. More products can therefore be produced at lower rates, thus adding more room for company profits. The improvement in labor and efficiency also boosts the quality of products, potentially increasing customer satisfaction and ultimately increasing consumer spending.

One potential drawback of increased consumer spending in the long-term economic growth of the host country is that if the aggregate demand outgrows the financial capacity of a region at the time, it will cause inflation in the country and not increase the GDP. This may lead to economic recession for a time until the capacity of the area increases.

The Multiplier Effect

For most developing countries and even developed countries with spare economic capacities, capital spending will improve the public and private market capabilities, and a rise in investment will lead to what is called the multiplier effect. As there is a rise in investment, the resultant economic growth leads to better capital goods, allowing firms to generate more sales and profit. More revenue flowing into companies will allow them to partake in more research and development activity that needs further investment. The additional investment leads to increased labor productivity and job availability. A reduced unemployment rate will allow households to generate more income that the public will spend as consumer spending. The return on investment for companies leads to more production, creating a cycle of investment.

Example of the Effects of Capital Investment on Economic Growth

The Bureau of Economic Analysis (BEA) highlighted the U.S. GDP growth rates for the years between 2016 to 2018 along with the factors that contributed to it in a report:

  • In 2016, the gross private and business investment was -0.24%, while consumer spending was 1.85%. These investments resulted in a GDP of 1.6% for the year.
  • When private investment increased in 2017, the GDP saw an increase as well – to 2.2%. The personal consumption expenditures for the year were only 0.12% lower than the preceding year.
  • As for 2018, the nonresidential investment, spending on equipment and structure, and overall business and private investment were much higher at 1.02%. Personal expenditures on consumption also increased to 1.80%, and the GDP for 2018 increased dramatically to up to 2.9%.

This data was a clear indicator of how economic growth in the U.S. was driven mainly by capital investment and consumer spending in the period. While the consumer spending was approximately the same in 2016 and 2018, it can be observed that the financial growth resulted from the level of capital investment.

The Bottom Line

Realizing the dynamic effects of capital investment is not immediate and may take several years. It is also highly dependent on the types of investment since some investments will lead to increased productivity over time, and some will not. Regardless of the investment sector, sustained growth will lead to a stable economy, reduced unemployment rate, increased physical capital, and more investment opportunities.