Question

(i) Define capital formation. 
(ii) Briefly discuss the process of capital formation.

Answer 1

(i)

Capital formation refers to net additions of capital stock such as equipment, buildings, and other intermediate goods. A nation uses capital stock in combination with labour to provide services and produce goods; an increase in this capital stock known as capital formation.

(ii)

There are mainly three stages in the process of capital formation. These are :
(i) Creation of savings
(ii) Mobilisation of savings and
(iii) Investment of savings.

(i) Creation of Savings: Saving is the first stage in the process of capital formation. Savings in a country are made by different individuals. These depend upon several factors like (a) ability to save (b) desire to save and (c) opportunity to save. The ability to save directly depends upon the level of income. The higher the income of people, the more will be their ability to save. Besides income, the taxation policy of the government also affects the ability to save.

When the rates of income tax and sales tax are high, people will be able to save only less amount than before. Opportunity to save refers to the conditions of peace and security in the country and the favourable attitude of the government to motivate people to save.

(ii) Mobilisation of Savings: Capital formation cannot occur unless savings made by people are mobilised for investment purposes. Savings are done by millions of households and firms. It is very important that these savings are mobilised and used for productive and investment purposes. This requires a network of banks and other financial intermediaries who collect these savings and make them available to the producers or investors. Without banks and other financial intermediaries, these savings would remain idle and might not be utilised for productive and investment purposes.

(iii) Investment of Savings: The third and last stage of capital formation is the investment of mobilised savings. Unless mobilised savings are not utilised or invested, there cannot be any capital formation. It is, therefore, necessary that the economy should have an entrepreneurial class that is prepared to bear the risk of business and invest savings in productive channels. The entrepreneurs will, however, get motivated only when

• the rate of interest is not very high and
• there are good expectations of profit.