CAPITAL FORMATION

DEWETT 148/154
 MEANING – CAPITAL
FORMATION
 capital formation means increasing the stock
of real capital in a country. In other words,
capital formation involves making of more
capital goods such as machines, tools,
factories, transport, materials, electricity etc
which are all used for future production of
goods.
 For making additions to the stock of capital,
saving and investment are essential
 PROCESS OF CAPITAL
FORMATION
• In order to accumulate capital goods,
some current consumption has to be
sacrificed.
• If society consumes all that it produces
and saves nothing, future productive
capacity of the economy will fall as the
present capital equipment wears out.
 Three stages in Capital Formation
• The process of capital formation consists
of the following three stages
2. Creation of savings
3. Mobilization of savings
4. Investment of savings
 CREATION OF SAVINGS

• Savings are done by individuals or

households. They save by not spending all
their incomes on consumer goods. When
individuals or households save. They
release resources from the production of
consumer goods. Workers, natural
resources, materials etc thus released are
made available for the production of
capital goods.
 Will to save
• Apart from the power to save, the total amount
of savings depends upon the will to save.
Various personal, family and national
considerations induce the people to save.
People save in order to provide against old age
and unforeseen emergencies. Some people
desire to save a large sum to start a new
business or to expand the existing business.
Also, people want to make provision for
education, marriage etc.
 Voluntary and Forced savings
• Savings may either voluntary or forced.
• Voluntary savings are those savings which
people do of their own free will.
• Taxes by the government represent forces
savings.
 MOBILIZATION OF SAVINGS
• Savings of the households must be mobilized
and transferred to businessmen or
entrepreneurs who require them for investment.
• In the capital market, funds are supplied by the
individual investors ( who may buy securities or
shares issued by companies), banks, investment
trusts, insurance companies, finance
companies, governments etc.
 INVESTMENT OF SAVINGS IN
REAL CAPITAL.
• For savings to result in capital formation, they
must be invested . In order that the investment
of savings should take place, there must be a
good number of honest and dynamic
entrepreneurs in the country who are able to
take risks and bear uncertainty of production.
• Investment will be made by entrepreneurs only if
there is sufficient inducement to invest.
Inducement to invest depends on the marginal
efficiency of capital ( ie the prospective rate of
profit) & rate of interest.
 Foreign capital
• Capital formation in a country can also take
place with the help of foreign capital, ie foreign
savings. Foreign capital can take the form of
• (a) direct private investment by foreigners, (b)
loans or grants by foreign govts,
(c) loans by international agencies like world
bank
• India is receiving a good amount of foreign
capital from abroad for investment and capital
formation under Five- Year Plans
 Deficit financing
• Deficit financing ie newly created money is
another source of capital formation. By
issuing more notes and exchanging them
with the productive resources, the
government can build real capital.
• The method of deficit financing as a
source of development finance is
dangerous because it often leads to
inflationary pressures in the economy.
DISGUISED UNEMPLOYMENT
• For example, surplus agricultural workers can be
transferred from agricultural sector to non
agricultural sector without diminishing
agricultural output. The objective is to mobilize
these unproductive workers and employ them on
various capital creating projects, such as roads,
canals, building on schools, flood relief activities.
• In this way, the hitherto unemployed labor can
be utilized productively and turned into capital.
 CAPITAL FORMATION IN THE
PUBLIC SECTOR
• Capital formation takes place not only in the private
sector by individual entrepreneurs but also in the
public sector by government.
• Govt is building dam. Steel plants, roads, machine
making factories and other forms of real capital in
the country.
• There are various ways by which govt can get
resources for investment purpose or capital
formation. They are
4. Direct and indirect taxation
5. Public borrowing
6. Deficit financing
7. Profits of public sector undertakings
8. Loan from foreign countries and international
agencies
 Low capital formation in
Under-developed countries -- Reasons
• In most under developed countries, investment
is only 5% to 8% of the national income where
as in countries like USA and Japan, it
generally varies from 15% to 20% of the
national income and even higher.
• The main reasons are
3. Domestic savings are low
4. Dynamic entrepreneurs not investing
5. Inducement to invest is very weak
 INDIA-why low capital
accumulation
• We have
• “THE WILL TO SAVE
BUT THE POWER TO SAVE IS MISSING”
• Little margin between production and consumption
• Inducement to invest is negligible
• Agriculture in most primitive methods
• Transport and communication are inadequate
• Country is not equipped with adequate banking and
insurance
• It suffers from inflation
 REMEDIES
1. Production should be increased in all all spheres
by the development of agriculture, trade, industry,
transport, banking, insurance etc.
2. Compulsory insurance schemes should be
introduced.
3. Provident fund schemes should be extended.
4. Tax relief to industries
5. Stock exchange activities will ensure flow of
capital provided it gains confidence from investors
6. Distribution of wealth in the country
7. Small savings should be improved and attractive
rates of interest should be provided
The above are some of the measures which encourage
investment and help capita\l formation.