Capital Formation

CONTENTS
Meaning of capital
formation
Importance of capital
formation
Causes of low rate of
capital formation in
underdeveloped
countries
Measures to promote
capital formation in
Introduction:
Capital is defined as produced means of production. It
is man-made and its supply can be increased by
human effort. Capital stock of A country consists of
machinery , tools , factory buildings and all kinds of
industrial plants , raw materials , partly-finished goods
and means of transport . since the development of an
economy crucially depends upon the availability of
these things ,we can see that capital is essential
factor of development .The addition to the capital
stock of A country during A given year represents the
capital formation in that year.
Meaning of capital formation

Capital formation is the process of building up the
capital stock of a country through investing in
productive plants and equipments. Capital
formation, in other words, involves the increasing
of capital assets by efficient utilization of the
It may here
available
and
behuman
remembered
resources
thatofthough
the country.
capital
occupies a central position, to the process of
development yet, we cannot ignore the other factors
like education, effective government, social Justice,
attitude of the people to work, etc., etc. These factors
Economic
play
a significant
development
role in is
the
thus
economic
a multidimensional
progress of a
phenomenon which is the result of a combination of
country.
social, cultural, political, and economic factors.
Definitions:
A United nations study defines Capital as those
goods resulting from economic activity which are
used for the future production of other goods.
To quote Ranger Nurkse, Economic
development has much to do with human
endowments, social attitudes, political
conditions, and historical accidents. Capital is
necessary but not a sufficient condition of
economic progress".
According to Colin Clark , Capital goods

reproducible wealth used for purposes of
production.
are
The importance of capital formation as one of the

factors in economic development is discussed below:
1. Increase productivity of various sectors:
Capital formation increases the stock of material
and human capital. The productivity in
agriculture, manufacturing and mineral sector etc
increases.
2. Increase in national income:
Capital formation helps in raising national output
which in turn raises the rate and level of national
income.
3. Increase Employment:
The increased investment in various sectors of the
economy leads to increase employment
opportunities in A country.
4. Break The Vicious Circle Of Poverty:
It helps in breaking the vicious circle of
poverty in the underdeveloped countries .
5. Expansion Of Market:
Capital Formation Makes It Possible To
Produce The Goods On Large Scale. As The Good
Of One Industry Will Be The Inputs Of Other And
So On. Thus The Size Of The Market Will Be
Extended.
6. Control Inflation:
Capital formation increases the supply of goods
in the country. It thus helps in controlling inflation and
bringing stability in the economy in the long-run.
7. Self-sufficiency:
A country engaged in capital formation will be
able to produce a variety of goods and make the
country self-sufficient. This will reduce a countrys
dependence on foreign countries.
8. Correct Balance Of Trade:
Capital formation helps in building importsubstitution industries. The reduced demand of the
foreign goods helps in solving the problems of
adverse balance of trade.
9.
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.
10. Technological progress:
Technological progress requires higher rate of
capital formation. The technological improvements
helps in getting more output from the same
resources.
11. Building up of infrastructure:
The building up of sound infrastructure like
road, railways, communication system, power etc is
an vital significance of capital formation which helps
in breaking vicious circle of poverty.
Following Points Illustrate The Importance Of

Capital Formation In The Economic
Development:
* Capital Formation Is Vital For Economic Growth .
* Capital Resources Of A Country Increase
Investment And Needed Finance For The Industries.
* Capital Formation Helps In Eradicating The Vicious
Circle Of Poverty.
* Capital Formation Increase Investment And
Production Activities Which Results In More
Employment Opportunities For The Masses.
* Capital formation helps a country becoming self
sufficient and independent all foreign pressures.
* Expenditure on Human Resource Development
increases productivity and efficiency of work which
later translates into better and more production.
Sources of capital formation

There are two sources of capital formation :
A. Domestic Sources:
a. Voluntary savings by household and business sectors
b. Involuntary saving by transferring resources from
consumers and producers to government through taxation.
c. Government borrowing
d. Use of idle resources
e. Deficit financing
B. External Sources:
a. Foreign aid
b. Restrictions of imports
c. Direct foreign investment
The Additions Made To The Stock Of Capital Of An

Economy Directly Increase Its Productive
Capacity. There Is Much Closer Positive
Correlation Between The Rate Of Capital
Formation And Per Capita Incomes Than Between
The Capital-output Ratio And The Level Of
Income Of A Country.
The following are the causes of low capital

formation in underdeveloped countries :
Vicious Circle Of Poverty:

The low capital formation in underdeveloped
countries is attributed to vicious circle of poverty
which operates in underdeveloped countries . it is
because of VCP the incomes, savings, investment
and productivity of the people remains limited and
International
obstructed. Demonstration Effect:
According To Prof. Nurkse The Biggest Obstacle In The
Way Of Capital Formation In Ldcs Is The Existence Of
International Demonstration Effect. It Means That The
People Of Ldcs Have The Desire To Attain That Standard
Of Living Which Has Been Attained By Developed
Countries (Dcs); Their Consumption Pattern Must Be
Similar To Those Of Dcs And Their Educational Systems
Must Be Like Those Of Dcs. In Such Situation, The
People Of Ldcs Spend All Of The Increase In Their
Lack Of Proper Infrastructure:

In case of LDCs, there is an acute shortage of
infrastructure facilities like power, transport,
communication etc. thus in the presence of
inadequate infra-structure the domestic as well as
foreign investors are not prepared to invest. With
this the stock of capital and capital formation
remains low.
Inflation:
In UDCs, inflation is a very common phenomenon.
Because of persistent rise in general price level,
<Higher
Birth Rate>:
the Population
real incomesExplosion
of the people
decrease
In case their
of poor
countries
not only the volume
restricting
saving
potentials.
of population is very high but the rate of growth
of population is also significantly greater. In
such situation all of the incomes have to be
devoted to the rising umber of children and
nothing is left to be allocated for savings.
Unproductive Expenditures:
In Case Of Ldcs, The Lavish Expenditures Are Made
On Unproductive Fields Both By Individuals As Well
As By Governments. The Individuals Waste Their
Precious Savings By Spending Them On Traditions,
Customs And Litigations Etc. While Government
Make Expenditures On Unproductive Fields For
Example Political Purposes. Consequently A Little
Surplus Is Available For Capital Formation.
Unequal income distribution:
In Udcs, The Distribution Of Income And Wealth Is
Very Unequal. The Rich Do Not Care For Saving And
The Poor Have Very Low MPS. Thus Capital Formation
Remains Low.
Tax System:
In Udcs, The Tax Structure Is Also Responsible For
Low Capital Formation. In These Countries The
Indirect Taxes Are Imposed In A Greater Amount
Rather Direct Taxes. This Situation Also
Discourages The Saving Potential Of The People.
In This Situation, The Poor And Middle Class Of
The Udcs Hardly Contributes To Savings And
Capital Formation. On The Other Hand, The
Businessmen And Industrialists Are Always Found
Hectic Regarding Tax Evasion.
Problems Of Money Markets:
Money Market Is In Infancy In The Less
Developed Countries Which Is Not Fully
Contributing To Capital Formation.
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 From
The Same Resources.
Building Up Of Infrastructure:
The Building Up Of Sound Infrastructure Like
Road, Railways, Communication System, Power Etc
Is An Vital Significance Of Capital Formation Which
Helps In Breaking Vicious Circle Of Poverty.
In order to promote capital formation in

the underdeveloped countries , following
suggestions can be given:
Utilization Of Disguised Unemployed
Workers:
If The Disguised Unemployed Workers Are
Employed On Various Projects Like Irrigation,
Roads Etc
They of
Can
Begovernment:
A Fruitful Sources Of
Liberal
policy
the
Capital
Formation.
The
government
should have liberal credit,
fiscal and industrial policies. Due to the liberal
policy , saving and investment will be
encouraged and capital formation promoted.
Privatization Of Financial Institutions:

The Privatization Of Financial Institutions Can
Also Attract Savings Both At The Gross And
Higher Level By Providing Full Range Of
Banking Services To Customers. The
Impressive Performance Of The Financial
Institutions Can Help In Mobilizing Resources
Saving
For Development.
Drives:
Savings Of Both Types, Voluntary And Involuntary
Can Greatly Help In Capital Formation.
Setting Up Financial Institutions:
The Setting Up Of Financial Institutions In Urban
And Rural Areas Can Greatly Help The People To
Deposit Their Savings In Financial Institutions
Rather Than Keeping Them In Homes. The Small
And Larger Amounts Of Saving So Collected Helps
In Raising Funds For Development.
Foreign Aid:
If The Capital Is Not Adequate For Meeting The
Development Requirements Of The Country, Then
To Bridge The Savings-investment Gap, The
Country Has To Reply On Foreign Aid For
Economic Development.
Restrictions On Luxury Imports:
Another Source Of Capital Formation Is The
Imposition Of Restrictions On Luxury Imports. The
Foreign Exchange Thus Saved Could Be Used For
Public Borrowing:
Capital
Formation.
Public Borrowing Is An Effective Method Of
Capital Formation. Government Raises Loans
Through Sale Of Bonds And Saving Certificates
Etc.
Development Of Capital Markets:

Government Can Divert Resources From
Unproductive Channels By Strengthening The
Capital Market In The Country. The Establishment Of
Stock Exchanges Etc Can Go A Long Way In Capital
Formation.
Foreign Earning Through Exports Of
Physical Goods:
The Foreign Earning Through Boosting The Exports
Of Physical Goods To The Other Parts Of The World
Can Be Utilized For Capital Formation.
Foreign Remittance:
Foreign Remittance Refers To The Earning By
Services Export By The Inhabitants Of A Country. If
The Government Increase The Search To Find Jobs
For The People In Other Countries They Will Bring
Foreign Remittance To The Country Which Can Be

Capital Formation

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CONTENTS

Meaning of capital formation

According to Colin Clark , Capital goods

The importance of capital formation as one of the

Proper Utilization Of Natural Resources:

Following Points Illustrate The Importance Of

Sources of capital formation

The Additions Made To The Stock Of Capital Of An

The following are the causes of low capital

Vicious Circle Of Poverty:

Lack Of Proper Infrastructure:

Proper Utilization Of Natural Resources:

In order to promote capital formation in

Privatization Of Financial Institutions:

Development Of Capital Markets:

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