Financial Investment and Real Investment

The meaning of the term “investment” is different for economists than the rest of the world. When we ask our banker for investment, he / she would probably start taking about stocks, mutual funds, some deposit accounts or insurance products. But, for an economist, these purchases of financial assets are NOT investment simply for the reason that financial assets do not represent real net wealth for the economy as a whole. Rather, when somebody purchases a financial asset, it would reflect the credit relationship within the economy.  For example,

• Loans and bank accounts represent contracts to pay interest and repay principal on borrowed money.
• Stocks represent partial ownership of a corporation, or right to receive dividends etc.

In these cases, the financial asset of one party in the economy would be offset by a financial liability of another party. Thus, when we aggregate the wealth of all members of the economy, these assets and liabilities cancel and financial assets disappear. This implies that when I am investing in an asset, somebody is disinvesting at the same time. By my investment in a financial asset, the aggregate or social investment doesn’t increase. Such an investment only signifies change of ownership. This kind of investment has significance only from individual point of view; it has no importance from social point of view.

An economist would reserve the term investment for those transactions that increase the magnitude of real aggregate wealth in the economy. This implies that investment refers to creation / purchase of new durable assets such as factories and machines, which are used for production. Here please note that resale of the assets is not counted in such investments.

In the expenditure side computation of the National Income, the GDP is represented by a formula GDP = C + I + G + NX, where C is consumption, I is investment G is government spending, and NX is net exports, given by the difference between the exports and imports, X − M. By this, we can arrive at

I=GDP-G-NX

This means investment is everything that remains of total expenditure after consumption, government spending, and net exports are subtracted. This kind of investment results in net addition to the total capital stock of the society, causing increase in employment. This is called Real Investment.

Notable points: Real Investment

• Real Investment results in increment of capital equipment
• By real investment, we don’t mean to purchase the existing paper securities, bonds, debentures or equities, but the purchase of new factories, machines, railroads etc.
• Investment expenditure is a related concept, which refers to the expenditures which are done for producer’s durable equipments, new construction and the change in inventories.