Capital Formation

Capital formation is a macroeconomic concept that refers to creating additional tangible assets as a stock of net capital goods, for an economy, in a designated accounting period. It helps in future production. The prime purpose of capital accumulation is to increase the rate of net income of a nation along with its growth. 

It is necessary to calculate a country's GDP and help measure its financial health. The capital accumulation helps boost a country's manufacturing and services sector, leading to higher production within the country's economy. It is also needed to replace older goods to sustain production; otherwise, production falls.

• Capital formation is the creation of additional physical assets or capital goods by the collective savings in an economy to ensure that production continues in the future. It also creates human capital. 
• It helps in measuring a nation's GDP and its economic performance.
• Capital accumulation also helps in the growth of the country's economic production. Without capital accumulation, a country's production will fall and impact the economy negatively.
• Three steps to the capital accumulation process are savings creation, savings mobilization, and investment of savings for adding physical assets or capital.

Capital formation means a country's net addition of physical goods in an accounting period for the future production of goods and services. Economist Simon Smith Kuznets introduced this concept. It is the same as net capital accumulation. Adam Smith was the one who used the concept of capital accumulation to explain the reason why some countries are rich compared to others.

According to economists, capital accumulation has been the core of any economy's prosperity. It symbolizes the savings and investment ability of the households or government surplus, which can be used to generate real capital stocks for future uses. Abstinence in current consumption leads to investment in new capital. With an increased household income, savers may invest in stocks and bonds. Thus, countries report a cash surplus if savings increase. So, the more capital, firms, and institutions form, the more products and services they produce, increasing national income. However, production declines if a country fails to replace its old capital equipment. 

Sometimes, capital accumulation is termed as the gross domestic capital formation for that specified economy when there is a net increase in a country's physical asset due to the improvisation of household, state, and public savings. Domestic capital accumulation sources include government taxation, borrowing, voluntary saving, and deficit financing. Besides physical stock formation, capital accumulation also considers human capital formation. 

Capital accumulation also leads to an increase in the ratio of capital per labor. Firstly, production increases as countries with higher capital accumulation experience higher labor productivity, directly affecting the economy's growth through output enhancement. Secondly, it creates effective demand as an increase in per capita income raises the purchasing power.

There are two-component of capital accumulation - gross capital formation (GCF) & net capital formation (NCF). Gross capital accumulation is the gross investment of an economy, including net & replacement investments. So, it is capital accumulation calculated before the deduction of depreciation cost. On the other hand, Net capital accumulation is only the enhancement of net investment, estimated by subtracting depreciation value from the gross investment. The investment referred to here is also called the gross fixed capital formation (GFCF).

The World Bank is the authority over the calculation of gross capital formation of all countries. It calculates net changes and the variations in household savings of countries. It also reports government debt which can hamper capital investment. Countries with higher levels of income have higher rates of savings and investments. Examples include the United States and Western European countries.

Here is a capital accumulation example to understand this concept. A global computer chip maker ABC Corp., in Silicon Valley of America, supplies chips across the globe. Every nation uses these chips in their laptops, personal computers, and tablets. This company is listed on NASDAQ. So, it raises its investment by selling its shares, stocks, and debt instruments to the public.

Furthermore, if the global and American households have enough savings to invest in the stocks and debts of ABC Corp, in that case, it can expand its manufacturing facilities and establish manufacturing hubs in the capital of various countries to control the chip market and establish a monopoly. As a result, it will invest money in buying machinery, plant, and land to set up new factories and expand the existing ones. Thus, ABC Corp. can utilize the investment received by the public from their savings for capital accumulation. 

Thus, the capital accumulation of ABC Corp. will augment the country's capital stock formation for future uses.

Capital formation is an accumulation of additional capital assets like machinery, plant, transportation, raw materials, electricity, and utility projects for future production or manufacturing sectors to aid economic growth. Here are the three steps to the process of capital accumulation:

Step 1: Savings Creation

The first step in capital accumulation is the creation of sound savings by increasing the actual savings. People, i.e., the households, save more money than spending on consumer goods. So, the level of real savings is directly related to the citizen's income. The government also collects taxes and saves money. Moreover, savings depend on factors such as the capability to save, preparedness for savings, and avenues like banks and other financial institutions that facilitate savings.

Step 2: Savings Mobilization

Proper mobilization becomes paramount after the accumulation of savings. Mobilization of savings means to direct the funds accumulated through the savings of the government or household towards the businesses, entrepreneurs, or government for further investment in producing goods and services. 

Savers first deposit savings into any financial institution. They then provide them to business persons or firms for use in manufacturing products and services. Moreover, the extent of savings mobilization depends on the ease of availability of funds, hassle-free access to funds, secure financial systems, and savings plus banking practices of the citizens.

Step 3: Savings Investment.

Although savings are necessary, they do not directly produce capital goods until savers invest them wisely. Therefore, one must make appropriate savings-investment decisions after the savings and mobilization. The savings-investment is the investment of funds collected and capital borrowed from banks into buying tangible capital like plant machinery for future uses. Moreover, the fund made available for investment also depends on the rate of interest, government policies, degree of economic development, demand in the market, and marginal efficiency related to capital.

The above three steps are critical in capital accumulation as they add to the increase of capital stocks. As a result, there is an addition to the economy's capital, so the economy's production capacity increases.

This article has been a guide to Capital Formation and its Meaning. Here we discuss the components, process of capital formation along with an example. You can learn more from the following articles -  

• Capital Rationing
• Intellectual Capital
• Net Capital Spending