Capital formation Process:
Capital formation is a term used to describe the net capital accumulation during an accounting period for a particular country, and the term refers to additions of capital stock, such as equipment, tools, transportation assets and electricity. Countries need capital goods to replace the current assets that are used to produce goods and services, and if a country cannot replace capital goods, production declines. Generally, the higher the capital formation of an economy, the faster an economy can grow its aggregate income.
According to Todaro and Smith, “Capital accumulation is increasing a country’s stock of real capital.”
In order to add the capital stock, a country needs to generate savings and investments from household savings, or based on government policy. The Process of capital formation has the following 3 stages:
1. Increase in Savings:
The capital formation depends on saving. According to J.M. Keynes “Saving is the excess of income over consumption expenditure”. To be more precise, saving is a part of income that is not spent on current consumption. If consumers spend their entire incomes on consumers’ goods, there could be no accumulation of capital goods. If, on the other hand, consumers decide to save part of their incomes, the country’s resources can be devoted to making capital goods.
Saving depends upon the following factors:
a) Capacity to save:
The amount of money an individual can save depends upon his level of income, government policies and distribution of income in the economy.
b) Willingness to save:
A person is willing to save some portion of his income if the rate of interest is high or if he has a temperament (habit) for saving. Willingness to save also depends upon foresightedness of a person, family affection and social esteem.
c) Facilities to save:
A man willing to save would save only if there are facilities to save in the country. Such facilities are peace and security, investment opportunities, availability of financial institutions, money value stability, etc.
2. Mobilization of saving:
It is the second stage of the capital formation process. Creation of saving is not enough. People save money but this saving largely goes waste because saving is held in the form of idle balance (as in rural areas), or to purchase unproductive assets. This is why society’s actual savings falls below its potential savings. Thus, the generation of savings is just a necessary and not a sufficient condition of capital formation. To accelerate the rate of capital formation it is absolutely essential to mobilize it.
3. Investment of savings:
This stage involves the conversion of money-savings into the making of capital goods or investment. Banks and financial institutions convert the savings of the household sector into loanable funds. Such funds are acquired by business funds to invest in capital goods like a plant, equipment, machinery, etc. When business firms borrow money at the interest they do not keep the funds idle but invest.
They place an order for machines and structures and make advance payments to the suppliers of capital goods. Thus the third stage of capital formation is concerned with the investment of savings.