What is capital formation? Definition and meaning

Capital formation, also known as capital accumulation, refers to the increase in the stock of real capital in an economy during an accounting period (a year or a quarter). Capital formation involves the creation of more capital goods such as buildings, equipment, tools, machinery, vehicles, etc. which are used for producing goods and providing services.

In economics, capital means the factors of production that are used to create goods and services.

A country uses capital stock together with labor to produce goods and provide services. Capital formation occurs when this capital stock increases.

Usually, the greater the capital formation of an economy is, the faster it can grow its aggregate income.

Capital formationCapital formation depends on the mobilization of savings, which relies on people wanting to save money.

When a country’s capital stock increases, its capacity for production grows too, which means it is able to produce more. When more goods and services are produced, national income levels rise.

The concept of capital formation was pioneered during the 1930s and 1940s by Simon Smith Kuznets (1901-1985), an American economist, statistician, demographer and economic historian who won the 1971 Nobel Memorial Prize in Economic Sciences.

From the 1950s, it became used by most countries to measure capital flows.

Economists say capital formation is an essential way of assessing the true financial state of a country. It can help analysts identify the rate of GDP (gross domestic product) growth.

Capital formation in national accounts statistics

In national accounts, gross capital formation is the total value of GFCF (gross fixed capital formation), plus net changes to inventories, plus net acquisitions less disposals of valuables for a unit or sector.

In national accounting, total capital formation equals net fixed capital investment, plus the increase in value of inventories held, plus lending to foreign countries.

Capital is ‘formed’ when savings are used for investment purposes, often investment in production.

According to the Nasdaq Business Glossary, capital formation is:

“The expansion of capital or capital goods through savings, which leads to economic growth.”

Professor Ragnar Nurkse (1907-1959), an Estonian international economist and policy maker who served in the Financial Section and Economic Intelligence Service of the League of Nations from 1934 to 1945, and taught economics at the universities of Columbia, Princeton, Oxford and Geneva, said the following about capital formation:

“The meaning of ‘capital formation’ is that society does not apply the whole of its current productive activity to the needs and desires of immediate consumption, but directs a part of it to the tools and making of capital goods: tools and instruments, machines and transport facilities, plant and equipment— all the various forms of real capital that can so greatly increase the efficacy of productive effort…. The essence of the process, then, is the diversion of a part of society’s currently available resources to the purpose of increasing the stock of capital goods so as to make possible an expansion of consumable output in the future.”

The 3-step process of capital formation

Capital formation follows a process of three steps:

1. Growth in the volume of real savings.

2. Savings mobilization through credit and financial institutions.

3. Investment of savings.

Hence, the problem of capital formation becomes one of how to save more, plus how to utilize the community’s current savings for capital formation.

Capital formation also refers to the issue of new securities (shares and bonds), which occurs in the primary market.

Video – Capital formation

This 1955 government information video talks about relationship between savings, investments and capital formation.