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Capital Formation

Updated on June 11, 2012


Capital formation is one of the major factors in economic development. It is the increase in the stock of both material and human capital by making available a part of society's currently available resources. Capital formation results when some proportion of society's present income is saved and invested in order to increase material as well as human capital. The meaning of capital formation is that socitey does not apply to the needs and desires of immediate consumption but directs a part of it the making of capital goods, tools and instruments, machines and transport facilities, plants and equipment, all the various forms of real capital that can so greatly increase the efficiency of productive effort.''

Efficiency productivity of capital

In the modren economic life the importance of capital has increased. As human life depends upon circulation of blood likewise modern industrial system is running on the basis of capital. The importance of capital can be viewed from the following:

  • Gain from the Natural Resources. Utilisation of natural resources without capital is impossible, to reach mines and discover minerals, development of forests and cultivation of crop, capital is required.
  • Economic Development. Although goods are produced with the help of four factors of production and single factor of production is useless yet capital has gained an important position in the modern production structure. The economic condition of countries are now judged from capital possession.
  • Higher Living Standard. Capital halps in increasing agricultural, industrial, mineral, production and services development i.e., National Income. If the rate of increase in national income is greater than the population growth rate, living standard improves.
  • Efficiency of Labour. Capital increases the efficiency of labour. Labour can increase production with capital many times.
  • Decrease in the Cost of Production. With the involvement of capital, cost of production decreases, production increases and quality of product improves and people get it at lower price.

Significance of Capital formation.

The importance or significance of capital formation in the process of economic development of a country is briefly given below.

  • Building up of infrastructures. The building up of sound infrastructure like, road, railways, communication system, power etc. is an important significance of capital formation. It greatly helps in breaking the vicious circle of poverty in the country.
  • Adoption of modern techniques of production. Capital formation helps in the use of modern techniques and adoption of complex methods of production for rapid growth in production in large scale industries.
  • Qualitative improvement of human resources. Capital formation plays an important role in the qualities improvement of human resources. The expenditure incurred on human resource development like educations, health environmental protection, social welfare etc, contributes to better health of the people and in the total productivity of the country.
  • Proper utilization of natural resources. The adequate volume of capital formation makes it possible to utilize the natural resources of a country to the maximum extent and thus increase the rate of economic growth rapidly at a higher rate.
  • Technological progress. Technological progress requires higher rate of capital formation. The technological improvements helps in getting more output form the same resources.
  • Development of agriculture and industrial sectors. Capital formation helps in the modernization of agriculture and industrial sectors in a country. The use of latest techniques of production helps in lowering cost of production and increasing production.
  • Higher rate of growth in national income. Capital formation is playing an important role in rising the real per capital income and GDP of the country through improved productions in different sectors of the economy.
  • Expansion of economic activates. Capital formation helps in increasing the supply of goods in a country. It thus helps in controlling inflation and brining stability in the economy in the long run. Capital formation leads to increase in effective demand and also in investment.
  • Building import substitution industries. Capital formation helps in building and expansion of import substitution industries. The reduced demand of the foreign goods helps in solving the problem of adverse balance of trade.
  • Reduction of foreign debt. Higher rate of capital formation makes a country self sufficient in the production of goods and reduces the burden of foreign debt.

Sources of Capital Formation

There are two sources of capital formation:

(a) Internal Sources (b) External Sources

  • Internal Sources: Internal sources consist of domestic savings, borrowing from the public, taxes, deficit financing and external sources consist of grants, loans, investment and foreign aids.
  • Use of Hoardings: 70.5%of total population is living in rural areas, 65% of total population is literate and due to limited banking facilities people keep their savings in the shape of hoardings. They also keep gold and silver in the shape of ornaments for the sake of their dignity, pride and social status. In Pakistan 4% total national income is kept as hoardings and is not invested in productive purposes. For this it is necessary to increase the banking facilities in rural areas.
  • Through Taxes: If sufficient quantity of capital is not available through voluntary savings and by the use of hoardings the government receives amount through direct and indirect taxes for capital formation and for this purpose either new taxes are imposed or tax rate is increased. While imposing new taxes it is necessary that it should not affect private investment nor the burden of tax is as such that it lowers the purchasing power of the people. It is also necessary that tax collecting staff is honest hardworking and efficient and people do not avoid taxes.
  • Through Borrowing: Government can increase rate of capital formation through borrowing from the general public and financial institution but these borrowings should not hinder the private investment.
  • Domestic Savings: In developing countries saving rate is about 12% to 15% while it should be raised from 15% to 20% of GNP. Increase in voluntary savings is to restrict domestic consumption. Rigorous enforcement of existing taxes allows the government to force savings and reduce disposable income. But this method may increase involuntary savings and diminish voluntary savings. In Pakistan the ratio of saving to GNP is about 16% which is very low.
  • Public Borrowing: Government borrows from the individuals, by selling them its securities through central bank.
  • Restriction on Consumer's Imports: Restriction on imports will increase the savings of the individuals and this increase in savings will increase the rate of capital accumulation. To curtail consumption through inflation is also dangerous for development process.
  • To Remove Disguised Unemployment: To remove disguised unemployment is another way to increase capital formation. These unproductive workers can be employed on projects e. g. Roads, irrigation and construction with the nominal amount of capital. A shift of labour from agricultural sector to industrial sector, would make possible higher rate of development. It is a difficult approach as it involves the training for new jobs, additional capital equipment houses and other overhead capital. In agriculture sector there is disguised unemployment equal to 20%. Capital formation can be increased by removing disguised unemployment in rural sector. These unproductive workers can be employed on big projects like roads, irrigation and construction etc. with nominal investment. It will increase the income level of the people in rural sector. This technique will increase production and there will be no danger of inflation.
  • Deficit Financing: Deficit financing is regarded an important source of capital formation. In the developed countries this method is used for increasing effective demand and ensuring continued high levels of economic activity. In the less developed countries, it is used for generating savings by activating unemployed or underemployed resources. If capital is not available through traditional sources the government borrows from the Central Bank. Central Bank issues currency notes for this purpose without any guarantee which is called deficit financing. But this process is not free from danger because it creates inflation, if supply of goods and services does not match the existing demand.

If capital is not available through traditional source, the government borrows from the Central Bank. Central Bank issues currency notes for this purpose without any guarantee which is called deficit financing. But this process is not out of danger because it creates inflation if supply of goods and services does not match with economic activity.

  • External Sources: If internal sources are insufficient then rate of capital formation can be increased through external sources which include the following:
  • Foreign Aid and Loans: In present times some of the countries receive aid loans for development programmers and for other long term projects. These aids and loans can be received from governments, international financial institutions and other consortium countries. But these aids and loans should not be conditional and the rate of interest should be low.
  • Foreign Investment: Some of the International financial agencies have invested in Pakistan and have provided services of trained persons to increase the capital formation.
  • Decreasing Consumer Goods Imports: Foreign exchange can be saved by decreasing import of consumer goods and the saved foreign exchange can be used for the import of industrial raw material, machinery and modern technology.


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      Howard Schneider 3 years ago from Parsippany, New Jersey

      Excellent Hub and description of all the facets of capital formation, Saif113sb. It is an important key to economic development for any country.

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      Navpreet Dhillon 2 years ago

      This ideas depends on reality .l like it.

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