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What is the importance of investments for economic growth?

In the beginning, there is capital

The basis for any kind of investment is capital. From a macroeconomic perspective, capital is regularly created by foregone consumption. This foregone consumption is the result of a low time preference, which leads people to save and invest their surplus funds in order to consume at a later point in time. Thus, forgoing consumption creates the capital stock from which an economy can draw and make investments and grow.

Capital can come in different forms. The following, there are some examples:

  • Cash & other cash holdings
  • Securities
  • Means of production
  • Land and buildings
  • Intangible assets (e.g. rights, patents, concessions, knowledge)

The concept of investment

Basically, an investment is the use of capital by an entrepreneur for his business purposes.

Start-up investment

initial investment, for example, to procure the necessary operating resources as part of the establishment of a company.

Expansion investment

follow-up investment with the aim of increasing operational capacities.

Replacement investment

Follow-on investment with the intention of replacing obsolete or outdated operating equipment.

Rationalization investment

A type of replacement investment aimed at making operations more efficient or cost-effective.

Investments result in a number of effects that can have a positive impact on the overall situation of an economy.

Capacity Effect

Capacity effects refer to the increase in production potential that occurs as a result of an investment. This means that more and/or better goods can be produced. Namely, when replacement investments increase productivity and more output is produced with the same effort.

Income Effect

We speak of income effects when increasing investments create jobs, which in turn result in higher total national income, which also increases total consumption within the national economy. This in turn allows more to be saved, which leads to further investment and can result in an upward spiral.

Multiplier Effect

The multiplier effect is a measure that expresses how much total economic income is increased by the sum of investments made.

Why is economic growth needed?

There is no law of nature that an economy must grow steadily. However, there are reasons why it is favorable for an economy to increase its output. Indeed, as a country's economic performance increases, the wealth of the individual usually increases as well.

This in turn favors maintaining or even increasing the level of prosperity. A high and evenly distributed level of prosperity usually has a number of positive effects on society:

  • Less poverty and crime
  • Less violence
  • A higher level of education
  • A reduced rate of disease
  • An increased standard of living

Investments create economic growth & prosperity

As explained at the beginning of this article, capital is the basis for investments and economic growth is generated from these investments, provided that the investment projects can hold their own in the market. This will succeed if the goods or services produced to provide people with a benefit with which they can satisfy their needs. Thus, the additional social benefit generated by an investment is what increases people's quality of life and constitutes economic growth. Total economic output (gross domestic product) is measured in terms of the monetary value of all goods and services produced within the economy in one year, after deducting all intermediate inputs and adjusting for inflation.

Interest rates - the steering mechanism for capital

Now that we have discussed how economic growth comes about and why it can be important for an economy to grow, we turn to another important question. Namely, how capital finds its way into the right investments and which are the right investments. The latter is easily answered because from an economic perspective, the right investments are those that generate the greatest social benefit. One must not forget that capital is scarce, just like everything else. It must therefore be used wisely in order to generate the greatest possible benefit. The control mechanism responsible for this is the interest or the yield.

Through the interest rate, the market mechanism ensures that capital is preferentially provided to investment projects that are most profitable and can generate the highest interest or returns. The ability to generate high profits and returns results from the fact that these companies provide the most benefits to consumers and thus there is a strong demand for their products or services.

From the preceding explanations, it is clear that the capital market and its mechanisms are of enormous importance for the creation and maintenance of economic prosperity in an economy. Efficient capital allocation is the basis for sound economies in the 21st century. Instruments such as securities, i.e. stocks and bonds, are important factors in enabling companies to collect the necessary capital, which in turn can contribute to economic growth. The capital market enables anyone who manages to set aside some of their money to participate in this growth process by investing in stocks or other securities.