Investment is the flow of additions to the capital stock
during the period. The allowance for depreciation is often
called replacement investment---the amount that must be added to
the capital stock to replace the part that depreciated during
the period. If the rest of output is consumed, the capital
stock will be the same at the beginning of next period as it was
at the beginning of this period. And next period's output
and income will be the same as this period's output and income
(assuming that depreciation is the same).
Suppose that people decide to consume less than their
incomes. Then more will be added to the capital stock than
necessary to maintain it intact. The capital stock will grow
from this year to next and next year's income will be higher
than this year's income. This net addition to the capital stock
from this year to next is called net investment. Net investment
plus the allowance for depreciation is called gross investment
As was noted in the previous topic, the difference between gross
and net investment is depreciation.
Aggregate income can therefore be broken down into two
parts---consumption and net investment---according to whether it
is consumed or added to the capital stock. This relationship
can be stated in terms of the simple equation.
1. Y = C + I
where C is the level of aggregate consumption, Y is the level
of income and I is the level of net investment. It should be noted
here that we are lumping together privately produced and government
produced consumption and investment into single aggregates.
The level of gross investment equals net investment plus
depreciation:
2. Ig = I + D
where Ig is the level of gross investment and D is the allowance for
depreciation.
Output thus equals the sum of consumption and gross investment and can
be expressed as
3. X = Y + D = C + I + D = C + Ig
where X is the level of output.
The public's choice as to the division of income between consumption and
net investment is the fundamental factor determining how fast income will
grow from period to period. If aggregate consumption is less than
aggregate income, and net investment is therefore positive, the capital
stock and income will grow through time. If aggregate consumption is
greater than aggregate income, the capital stock and the income generated
by it will decline as time passes. Most industrial countries have
experienced substantial growth in output and income over the past 150 years.
This could not have occurred without growth of the capital stock over that
period. And the growth of the capital stock could not have occurred unless
consumption was consistently less than income.
It must be remembered that we are defining the stock of capital very
broadly here to include knowledge and technology as well as natural
resources, human skills, buildings, machinery and inventories. The growth
of knowledge and technology is often referred to as technological change.
While some technical advances occur by accident, most of the important ones
require investment of human and physical capital services. Those capital
services have to be diverted from producing consumer goods in order to be
used in the production of knowledge and technology.
An understanding of why some economies grow and others do not thus requires
an understanding of why some societies consume less than their income while
others consume all of it.
Two other conditions for growth of income, as we usually think of it,
to occur should also be mentioned briefly, although these details belong in a more
advanced discussion. First, for income per person to grow the economy's
capital stock must grow faster than its population. So to understand why
people in some parts of the world get richer as time passes while those
in other places do not, we also have to understand why the population grows
slower in some places than in others.
The second additional condition for growth to occur is that newly added
capital stock must make the same contribution to output as did the capital
stock previously in place. In other words, income that is diverted from
consumption into investment must not be wasted or improperly allocated
among the different types of capital. For example, knowledge and
technology must expand appropriately in relation to other kinds of
capital.
It's time for the test. Make sure you have thought through
the questions and arrived at your own answers before looking at the
answers provided.
You should now understand three basic points: 1) that the
output produced in an economy is the flow of returns off its
aggregate capital stock; 2) that income is the amount of that
output flow left after a sufficient portion has been diverted to
replace capital stock that depreciated or wore out during the
period; and 3) that income is therefore the amount that can be
consumed while maintaining the capital stock and the economy's
ability to produce income in the future constant.