capital is born out of savings.
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Capital formation is a term used to describe the net capital accumulation during an accounting period for a particular country. The term refers to additions of capital goods, such as equipment, tools, transportation assets, and electricity. Countries need capital goods to replace the older ones that are used to produce goods and services. If a country cannot replace capital goods as they reach the end of their useful lives, production declines. Generally, the higher the capital formation of an economy, the faster an economy can grow its aggregate income.
How Capital Formation Works
Producing more goods and services can lead to an increase in national income levels. To accumulate additional capital, a country needs to generate savings and investments from household savings or based on government policy. Countries with a high rate of household savings can accumulate funds to produce capital goods faster, and a government that runs a surplus can invest the surplus in capital goods.
Example of Capital Formation
As an example of capital formation, Caterpillar (CAT) is one of the largest producers of construction equipment in the world. CAT produces equipment that other companies use to create goods and services. The firm is a publicly traded company, and raises funds by issuing stock and debt. If household savers choose to purchase a new issue of Caterpillar common stock, the firm can use the proceeds to increase production and to develop new products for the firm’s customers. When investors purchase stocks and bonds issued by corporations, the firms can put the capital at risk to increase production and create new innovations for consumers. These activities add to the country's overall capital formation.
Reporting on Capital Formation
The World Bank works as a source of financial and technical assistance to developing countries, with an aim to end extreme poverty through its programs. The World Bank tracks gross capital formation, which it defines as outlays on additions to fixed assets, plus the net change in inventories. Fixed assets include plant, machinery, equipment, and buildings, all used to create goods and services. Inventory includes raw materials and goods available for sale.
The World Bank measures capital formation by assessing the change in net savings. If the household savings rate is increasing, savers may invest the additional dollars and purchase stocks and bonds. If more households are saving, the country may report a cash surplus, which is a positive sign for capital formation. The World Bank also reports the amount of government debt that a country’s central government has outstanding, as compared with the country’s gross domestic product (GDP), which is the total of all goods and service produced by a country. If a country’s rate of capital formation increases, so does the country’s GDP.
Related Terms
Gross Domestic Product (GDP)
Gross domestic product (GDP) is the monetary value of all finished goods and services made within a country during a specific period. more
Investment Definition
An investment is an asset or item that is purchased with the hope that it will generate income or appreciate in value at some point in the future. more
What Is a Deficit?
A deficit occurs when expenses exceed revenues, imports exceed exports, or liabilities exceed assets. Federal budget deficits add to the national debt. more
Economics
Economics is a branch of social science focused on the production, distribution, and consumption of goods and services. more
Quantitative Easing (QE) Definition
Quantitative easing (QE) refers to emergency monetary policy tools used by central banks to spur iconic activity by buying a wider range of assets in the market. more
Incremental Capital Output Ratio (ICOR)
The incremental capital output ratio assesses the marginal investment capital amount necessary for an entity to generate the next unit of production. more
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