Capital formation or accumulation of capital adds to the stock of an economy and thereby raises its productive capacity. The rate at which capital is formed and its pattern determines the growth and structure of capital stock. Both these aspects of capital have a great bearing in the development of an economy. The capital refers to structures and equipments. Structures include private residential houses, commercial and Govt, buildings. Under equipments are included durable consumer goods, durable capital goods like plants and machinery etc. and inventories such as stocks of raw material, finished and semi-finished goods lying in stores for sale.
Gross domestic capital formation is the addition to the total capital stock of a country’s own territory during a given year. It is the difference between the production and consumption account of an economy during a given year. This difference or surplus that goes to add to its capital stock is called gross domestic capital formation. Gross domestic capital formation includes gross addition to fixed capital formation and increase in stock of inventories. Thus gross domestic capital formation determines the economic growth. Other things being constant, the rate of economic growth directly depends on the rate of capital formation. Gross rate of capital formation is the ratio between gross capital formation and gross domestic product. Gross domestic capital formation =
Sources of financing gross domestic capital formation:-
There are various sources of financing gross domestic capital formation of an economy. They are given below.
(2) Consumption of fixed capital or depreciation.
(3) Net capital transfer from the rest of the world.
(4) Net borrowing from the rest of the world.
The significance of adequate saving needs no stressing. Saving is needed to finance capital formation or investment so as to increase and maintain the productive capacity of the country. Excess of current income over current expenditure is called capital formation. Savings constitute the main sources of gross domestic capital formation. There are several sources these are classified into three main sectors, namely the house hold sector, the private corporate sector and the public sector.
The house hold sector is comprised of individuals, non-movement, non-corporate entities in agriculture, trade and industry etc. The saving of this sector comes out of surplus after meeting the consumption expenditure. A part of the saving of this sector takes on the form of physical assets. The saving equivalent to the value of there physical- assets is included in the saving of the house hold sector.
The private corporate sector includes the non-Govt. corporate sector. Private sector also saves in the form of undistributed profit which is utilized to increase the productive capacity of the producing units. Thus the contribution of private corporate sector to saving consists of the “retained profits” arrived at after meeting all the expenses of the business including payment of corporate tax.
The public sector consists of the Govt, and the Govt, departmental and non-departmental under takings. The saving of this sector comes from the excess of current revenue over current expenditure, and the profits of the undertakings. However, the contribution of public sector to saving is not very encouraging. The contribution of household sector, Private Sector and Public sector to the savings constitution 78.1%, 12.4% and 9.5% respectively.
(2) Consumption of fixed Capital (Depreciation):-
In the production process, certain amount of fixed capital is used up. This is called depreciation of fixed capital or consumption of fixed capital. In the production prices fixed capital goods like machinery, buildings etc. get depreciated due to wear and tear.
Thus capital assets need repairing. The production will fall unless the depreciated capital is replaced. In order to maintain same level of fixed capital and increasing productivity annually there must be the provision to replace the worn-out machinery. The fund thus created towards meeting depreciation constitutes another source of gross domestic capital formation. The household, private corporate enterprises keep a part of their income in the format depreciation fund. The Govt, sector is assumed to have nil consumption of fixed capital. In order to arrive at net domestic capital formation, the source of depreciation fund is excluded.
(3) Net Capital transfer from the rest of the world:-
Capital transfers refer to the payments which are made in cash or in kind for the purpose of gross capital formation or other forms of accumulating or long term expenditure of the recipient. These grants are provided out of the stock of wealth and savings of neither do nor country. Capital transfer from the rest of the world refers to the follow of grants into an economy from abroad. These grants are irregular.
Such capital transfers are primarily made to form physical assets. These capital transfers are. In the form of economic aid, war damages, capital goods like machines and tools etc. grants, to finance deficit in external trade. Through capital transfers underdeveloped countries build up their national capital so as to boost up economic growth. A recipient country in the process of capital transfer also extends help to other countries.
Thus the next capital transfer can be arrived at by deducting the total capital transfer paid by a country to other countries from the total capital transfer it receives from -the rest of the world. The net capital transfers from the rest of the world and considered as a source of gross domestic capital formation.
(4) Net borrowing from the rest of world:-
Borrowing is a contractual transaction Govt borrows from the rest of the world to speed up economic growth. Net borrowings refer to the excess of net foreign liabilities over net acquision of financial assets. When our Govt, borrows from other countries or foreigners invest in our country, our country incurs liability to that extent. When borrowing is redeemed or foreigners withdraw their capital, our foreign liabilities decline. The difference between the receipt and payment of flows constitutes net incurrence of foreign liabilities.
As against the above, our country also given loans to other countries or our citizens invest in other countries. This will help increase our financial assets our investment and giving loan to other countries are called acquisition of financial assets abroad. When foreigners repay our loans or we withdraw foreign investments, our financial assets decline. The difference between the two flows is not acquisition of financial assets.
Thus the difference between net incurrence of foreign liabilities and net acquisition of foreign financial assets is called set borrowing from the rest of the world. This excess amount will go a long way to build up capital in our country.