Meaning of Capital Formation:

Capital formation means increasing the stock of real capital in a country.

In other words, capital formation involves making of more capital goods such as machines, tools, factories, transport equipment, materials, electricity, etc., which are all used for future production of goods.

For making additions to the stock of Capital, saving and investment are essential.

Process of Capital Formation:

In order to accumulate capital goods some current consumption has to be sacrificed. The greater the extent to which the people are willing to abstain from present consumption, the greater the extent that society will devote resources to new capital formation. If society consumes all that it produces and saves nothing, future productive capacity of the economy will fall as the present capital equipment wears out.


In other words, if whole of the current productive activity is used to produce consumer goods and no new capital goods are made, production of consumer goods in the future will greatly decline. To cut down some of the present consumption and wait for more consumption in the future require far-sightedness on the part of the people. There is an old Chinese proverb, “He who cannot see beyond the dawn will have much good wine to drink at noon, much green wine to cure his headache at dark, and only rain water to drink for the rest of his days.”

Three Stages in Capital Formation:

Although saving is essential for capital formation, but in a monetized economy, saving may not directly and automatically result in the production of capital goods. Savings must be invested in order to have capital goods. In a modern economy, where saving and investment are done mainly by two different classes of people, there must be certain means or mechanism whereby the savings of the people are obtained and mobilized in order to give them to the businessmen or entrepreneurs to invest in capital.

Therefore, in a modern free enterprise economy, the process of capital formation consists of the following three stages:

(a) Creation of Savings:


An increase in the volume of real savings so that resources, that would have been devoted to the production of consumption goods, should be released for purposes of capital formation.

(b) Mobilization of Savings:

A finance and credit mechanism, so that the available resources are obtained by private investors or government for capital formation.

(c) Investment of Savings:


The act of investment itself so that resources are actually used for the production of capital goods.

We shall now explain these three stages:

Creation of Savings:

Savings are done by individuals or households. They save by not spending all their incomes on consumer goods. When individuals or households save, they release resources from the production of consumer goods. Workers, natural resources, materials, etc., thus released are made available for the production of capital goods.

The level of savings in a country depends upon the power to save and the will to save. The power to save or saving capacity of an economy mainly depends upon the average level of income and the distribution of national income. The higher the level of income, the greater will be the amount of savings.

The countries having higher levels of income are able to save more. That is why the rate of savings in the U.S.A. and Western European countries is much higher than that in the under-developed and poor countries like India. Further, the greater the inequalities of income, the greater will be the amount of savings in the economy. Apart from the power to save, the total amount of savings depends upon the will to save. Various personal, family, and national considerations induce the people to save.

People save in order to provide against old age and unforeseen emergencies. Some people desire to save a large sum to start new business or to expand the existing business. Moreover, people want to make provision for education, marriage and to give a good start in business for their children.

Further, it may be noted that savings may be either voluntary or forced. Voluntary savings are those savings which people do of their own free will. As explained above, voluntary savings depend upon the power to save and the will to save of the people. On the other hand, taxes by the Government represent forced savings.

Moreover, savings may be done not only by households but also by business enterprises” and government. Business enterprises save when they do not distribute the whole of their profits, but retain a part of them in the form of undistributed profits. They then use these undistributed profits for investment in real capital.


The third source of savings is government. The government savings constitute the money collected as taxes and the profits of public undertakings. The greater the amount of taxes collected and profits made, the greater will be the government savings. The savings so made can be used by the government for building up new capital goods like factories, machines, roads, etc., or it can lend them to private enterprise to invest in capital goods.

Mobilization of Savings:

The next step in the process of capital formation is that the savings of the households must be mobilized and transferred to businessmen or entrepreneurs who require them for investment. In the capital market, funds are supplied by the individual investors (who may buy securities or shares issued by companies), banks, investment trusts, insurance companies, finance corporations, governments, etc.

If the rate of capital formation is to be stepped up, the development of capital market is very necessary. A well- developed capital market will ensure that the savings of the society-will be mobilized and transferred to the entrepreneurs or businessmen who require them.


Investment of Savings in Real Capital:

For savings to result in capital formation, they must be invested. In order that the investment of savings should take place, there must be a good number of honest and dynamic entrepreneurs in the country who are able to take risks and bear uncertainty of production.

Given that a country has got a good number of venturesome entrepreneurs, investment will be made by them only if there is sufficient inducement to invest. Inducement to invest depends on the marginal efficiency of capital (i.e., the prospective rate of profit) on the one hand and the rate of interest, on the other.

But of the two determinants of inducement to invest-the marginal efficiency of capital and the rate of interest—it is the former which is of greater importance. Marginal efficiency of capital depends upon the cost or supply prices of capital as well as the expectations of profits.


Fluctuations in investment are mainly due to changes in expectations regarding profits. But it is the size of the market which provides scope for profitable investment. Thus, the primary factor which determines the level of investment or capital formation, in any economy, is the size of the market for goods.

Foreign Capital:

Capital formation in a country can also take place with the help of foreign capital, i.e., foreign savings.

Foreign capital can take the form of:

(a) Direct private investment by foreigners,

(b) Loans or grants by foreign governments,

(c) Loans by international agencies like the World Bank.


There are very few countries which have successfully marched on the road to economic development without making use of foreign capital in one form or the other. India is receiving a good amount of foreign capital from abroad for investment and capital formation under the Five-Year Plans.

Deficit Financing:

Deficit financing, i.e., newly-created money is another source of capital formation in a developing economy. Owing to very low standard of living of the people, the extent to which voluntary savings can be mobilised is very much limited. Also, taxation beyond limit becomes oppressive and, therefore, politically inexpedient. Deficit financing is, therefore, the method on which the government can fall back to obtain funds.

However, the danger inherent in this source of development financing is that it may lead to inflationary pressures in the economy. But a certain measure of deficit financing can be had without creating such pressures.

There is specially a good case for using deficit financing to utilise the existing under-employed labour in schemes which yield quick returns. In this way, the inflationary potential of deficit financing can be neutralized by an increase in the supply of output in the short-run.

Disguised Unemployment:

Another source of capital formation is to mobilize the saving potential that exists in the form of disguised unemployment. Surplus agricultural workers can be transferred from the agricultural sector to the non-agricultural sector without diminishing agricultural output.

The objective is to mobilize these unproductive workers and employ them on various capital creating projects, such as roads, canals, building of schools, health centres and bunds for floods, in which they do not require much more capital to work with. In this way’, the hitherto unemployed, labour can be utilised productively and turned into capital, as it were.

Capital Formation in the Public Sector:


In these days, the role of government has greatly increased. In an under-developed country like India, government is very much concerned with the development of the economy. Government is building dams, steel plants, roads, machine-making factories and other forms of real capital in the country. Thus, capital formation takes place not only in the private sector by individual entrepreneurs but also in the public sector by government.

There are various ways in which a government can get resources for investment purposes or for capital formation. The government can increase the level of direct and indirect taxation and then can finance its various projects. Another way of obtaining the necessary resources is the borrowing by the Government from the public.

The government can also finance its development plans by deficit financing. Deficit financing means the creation of new money. By issuing more notes and exchanging them with the productive resources the government can build real capital. But the method of deficit financing, as a source of development finance, is dangerous because it often leads to inflation­ary pressures in the economy. A certain measure of deficit financing, however, can be had without creating such pressures.

Another source of capital formation in the public sector is the profits of public undertakings which can be used by the government for further investment. As stated above, government can also get loans from foreign countries and international agencies like World Bank. India is getting a substantial amount of foreign assistance for investment purposes under the Five-Year Plans.