The Circular Flow and GDP
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Investment and consumption
What I want to do in this video is compare investment to consumption. And we're going to think about it in two contexts. One I would call the everyday conventional context. And then the other one would be how we would think about it in an economics context. Because these words mean something very particular to an economist. And that's important that it means something particular, because we're going to start using these words, or this terminology, or these classifications, to understand where GDP is coming from. So in everyday-- let me draw a line over here. This is going to be everyday or, conversational, versions of this term. And down here, we'll put the economics, the economic versions of this term, especially when we think of it in the context of accounting for GDP. And they're not necessarily all that different. But they are different in important ways. So in investment, really in both cases, you can generally view it as something that you do to get some future gain. So for example, if I today build a house-- so I build a house. So that is the house. I built it today. And this will be the timeline. The house will keep lasting. And it's an investment, because it's going to be giving me future gain. A year from now, I'll still be able to live in that house. So I will have the saved rent. That's a future gain, a future gain two years from now. It'll keep giving some type of gain. You could have a financial instrument, maybe some type of debt instrument. You're lending money to someone else. So maybe you buy a bond, which is essentially you lending money to someone else. That is an investment in the everyday sense of it. Because when have that asset, when you've bought that asset, it's going to pay off something in the future. It's going to pay off some interest or some profits. And in the everyday sense, I would consider something like-- hopefully it would be-- going to college would be an investment. So education, I'll say education, because you invest that time and energy and education, it's going to keep paying off. Hopefully by doing that, you're going to get better employment and higher wages the rest of your life. It will keep paying off. So this is the everyday notion of investment. The everyday notion of consumption, the way I think about it, is you are buying something or you're doing something that you're just going to use up in the short-term. And just by using it up, whatever that object is, if you just use it up-- and it's just going to hopefully benefit you in some way, but it's more of a short-term thing-- I would consider that consumption in the everyday sense. So if you go buy a candy bar and eat it, you have consumed the candy bar. You have not made an investment. If you go to a movie, that is consumption. And I'm not making any value judgment that one is better than the other. Investment, at the end of the day, you're investing so that you can get future benefit that could lead to consumption. Because at the end of the day, consumption is one of the things that might make your life a little bit better off. So I'm not saying that one is better than the other. But watching a movie, that would also be consumption. Spending time buying a book, well, you could debate whether that's education or not. But let's say you buy a book that is not educational, that is consumption. But it is making you happier. Hopefully, it's making your life better in some way. Now, the economic definitions are related to these everyday definitions, but they're a little bit more precise. And they make the definitions in a way that they're easier to account for if you are a nation. They're easier to keep track of. So the way an economist would define it, they would define economic investment as spending on capital equipment. Capital equipment are things like, if you are a factory, you will buy the equipment to run your factory. You buy the robots. And you buy the assembly line. And you buy the wheelbarrows or whatever else, the things that have to cart things around. That is capital equipment. It would be things like inventory. So for example, the inventory-- and this is still not so different. Both of these things are being used to produce things in the future, to produce future benefit. You're buying that inventory, sometimes raw material, you're going to add value to it. And then they're going to be used to produce something in the future. It includes things like even the structures, the buildings. And so for all of this, in the economic sense, and this is why it's easier to account for, this, for the most part, is being done by the firms. And it also includes the one thing that households do, which is construction of new homes. This is from the households. Actually, the buying of a house does not show up in consumption or investment, because nothing new was produced. Something just exchanged hands. So whenever we talk about any of these things, especially when we're talking about it in precise economic terms, it's the production of new capital equipment, new inventory, new structures, new homes. If I just buy a factory from someone else, that does not add to GDP. It would not be considered investment or consumption, because I'm just transferring an asset from one person to another. It would only be added to GDP when it is first created. And on the consumption side, from an economic point of view-- let me draw a little bit of a line right over here-- consumption is considered to be any spending on final goods by households except for new homes. And let me make this even clearer. Because remember, if we're just transferring goods, that shouldn't count. So let me put it on newly produced final goods. Now, what's unintuitive a little bit over here is, according to the way we account for GDP, the tuition that you spend on a college education, that is new spending on final goods. And here are the final goods or services. The service you're getting is your education. That would be consumption. So education would fall here in the economic sense. While in the every day sense, I would consider education right over here. Maybe you are buying a car. And you're not buying a car for leisure purposes. You're buying a car because you need your car to go to work. There's an argument that that would be an investment in the everyday sense. By having that car, you have something that can take you to work every day. So you're getting future benefit. So there's an argument that maybe that's an investment in the everyday sense. But in the accounting sense, that car would sit right here. You bought a new car. But that is considered consumption. You did not buy a new house. And the whole reason, at least as far as I understand, why it's set up this way is this is this easier to account for. You look at all of the spending by firms, that's easy to account for. You essentially call that investment. Because at the end of the day, all the spending that firms are making is they're doing it to produce some good or service. So we call this investment any spending that the firms do. And on top of that, when households purchase new homes, we also call that investment. And that's just easier for the accounting offices of governments to keep track of. And everything else that households do, we consider consumption. And we'll see in the next few videos, there are a few other categories in terms of things that the government do. And then we'll have to think about imports and exports.
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