Millennia ago, our cave-dwelling ancestors discovered that planting some of their grains ensured that they had enough grains in the future. This principle works even today. Instead of consuming everything now, we use some of our resources to make new facilities of production. This whole process of creating new facilities for more production is called “capital formation” in the textbooks of economics. As old facilities die, capital formation, acting like a growth hormone, ensures that our economy keeps growing smoothly by using newly created facilities.
Johnny: Sometimes I really can’t stop thinking, Jinny.
Jinny: Oh, really? What’s boiling now in your mind’s furnace?
Johnny: Some economists always keep harping that the secret of economic growth lies in ensuring a good rate of capital formation. Riding on the back of creative instincts, we have moved from the Stone Age to the age of microchips. But I was just wondering, how much has the mass of our earth really changed with the ages of capital formation?
Jinny: Well, even with all our skyscrapers and jumbo jets, the mass of our earth remains the same as what it was when our ancestors used to live in caves. During many years of our existence, we have just made new things by putting together what was already lying on the planet.
I sometimes really wonder how nice it would have been if new clothes and new cars could simply come out on their own without our lifting a finger. But to get new things, we need to make a conscious effort. We need elaborate mechanisms for producing what we need for our consumption. We, in fact, require factories where the task of actually putting things together can be carried out. So we need to use some of our resources for new factories and new roads and bridges that help us in producing more of what we need tomorrow. This is the essence of what we mean by the term capital formation.
Johnny: The essence seems to be quite noble and simple. But tell me Jinny, what does an economist mean when he talks about capital formation?
Jinny: Economists talk about capital formation in terms of savings and investments.
Saving of money represents our conscious effort to forego consumption in the present in favour of future consumption. Investment represents our desire to use our present resources pending our future consumption.
Here we need to clarify two things. First, saving in itself cannot lead to capital formation. Second, all investments do not automatically lead to capital formation.
Capital is said to be formed only when the money saved is invested in the production of goods that help in the production of more goods. So putting your money in gold may be a good investment in terms of what is popularly understood by investment but it does not lead to capital formation.
Illustration: Jayachandran / Mint
Similarly, your buying a new car does not lead to capital formation. It is only when money is used for making new factories, new machines, and new nuts and bolts that capital formation takes place. It is this capital formation that determines the future growth potential of an economy.
We can value capital formation either on a net basis or on a gross basis. The net capital formation is calculated by deducting the depreciated value of the existing capital from the total value of capital and the gross capital formation is calculated without accounting for such depreciation.
Johnny: I don’t want to go much into how capital formation is measured. Tell me Jinny, what factors ultimately influence capital formation?
Jinny: First and foremost, the size of actual saving and investment by different entities in an economy determines how much of the present resources are likely to be utilized for capital formation.
As I said earlier, all savings do not end up as investments and all investments do not automatically lead to capital formation. But as a general rule, we can say that the higher the savings, the higher the chances of these being utilized in investments leading to capital formation. That doesn’t mean that the actual level of investment is always lower than the actual savings.
Sometimes actual investments may be higher than actual savings. A situation like this arises when people from outside the country are bringing in money for investments in that country.
In another situation, you may find that the level of investments is less than the actual savings. This could be due to several factors. Maybe the residents of that country are making investments in some other country or maybe the economy is going through a recession and there is no demand for more goods and services.
In a nutshell, all macroeconomic factors that affect economic growth have an effect on capital formation.
Johnny: But that’s not all, Jinny. I think we also need to focus on human capital. I will ask you about that some other time. For now, let me go back to my thinking furnace.
What: The use of resources for creating more facilities of production is called capital formation.
How: Saving resources in the present leads to investments which in turn determine the level of capital formation.
When: Actual investments are higher than domestic savings when foreign investors make investments in a country.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at firstname.lastname@example.org