An Empirical Investigation into the Relationship between Investment and Economic Output / Growth

Authors Avatar

An Empirical Investigation into the Relationship between

Investment and Economic Output / Growth


We will be investigating if there is a relationship between Investment and economic output in Greece between 1970 and 2004. Although we have relatively minimal initial knowledge about the Greek economy, we feel it is fair to assume (as a developed economy) Investment and GDP will be strongly positively correlated.

AD/AS Analysis:-

National Income Identity:

YD↑ = C + I↑ + G + (X – M)

The above is known as the ‘National Income Identity’, though is often referred to as the equation for aggregate demand. By definition an increase in Investment in this diagram will lead to an increase in national income as Investment is part of the equation.

Cobb Douglas Function:

YS↑= f (K↑, L)

Potential output within the economy is identified by the Cobb Douglas function. It links capital stock and the labour force with total output. Increased Investment in the economy leads to more capital stock (e.g. new machines), causing an increase in potential output. This will increase Greece’s productive capacity.

Actual Output:

Y↑ = min (YS, YD) ↑

Actual output is equal to the minimum of both demand and supply. As increasing Investment therefore has the effect of increasing both aggregate demand and supply, GDP will undoubtedly rise. 

If we demonstrate this graphically using AD/AS analysis, the initial process would be a rightward shift of AD resulting from higher Investment and Price Level increases from P to P1 but the same output.

Higher Investment within the economy will cause the rightward shift the AS curve, eventually returning Prices approximately to P. This should mean, unlike expansionary fiscal policies which just increase aggregate demand, GDP rises without too much inflationary pressure.

Production Possibility Frontier Theory:

The Production Possibility Frontier is the maximum level of output a country can produce given its current factors of production (capacity). Assuming Greece is operating at the maximum level of efficiency on its production possibility frontier, an increase in Investment will shift PPF outwards in the long run.

This means the country is able to produce more capital goods and more consumer goods due to improved machinery and better research and development. As a result of this output rise there will be increased GDP.

Data Collection

This was the data in original form (after separating text to columns from original csv form)

Join now!

For the years 1970-2004 we obtained data from the Penn World Tables (PWT) for the following variables in Greece:

  • Population (000s) – POP
  • Real Gross Domestic Product per Capita ($) – cgdp
  • Investment Share of cgdp (%) – ci

The Real GDP/Capita data was obtained by PWT from the World Bank which had calculated the data. We chose to use Real GDP/capita as it takes into account the effects of inflation.

Final Data Table Modifications:

From the original data we removed the country and isocode columns as we felt they were superfluous to ...

This is a preview of the whole essay