Question

Explain the process of capital formation. State two reasons why capital formation is important for economic growth?

Answer 1

Creation of capital is known as capital formation.

The stages are:

1. Creation of savings : Capital formation depends on savings. Saving is that part of national income which is not spent on consumption goods.

2. Conversion of savings into investment : To accelerate the rate of capital formation it is absolutely essential to convert savings into investible resources. Thus, the second stage of capital formation is concerned with channelizing the savings of the household sector and convert these into loanable funds.

3. The actual production of capital goods : This stage involves the con­version of money-savings into the making of capital goods, or what is known as investment. The latter, in turn, hinges on the existing technical facilities available in the country, existing capital equipment, entrepreneurial skill and venture, rate of return on investment, rate of interest, govern­ment policy, etc.

Two reasons why capital formation is important for economic growth are:-
1) Capital accumulation is necessary to provide people with tools and implements of production. If the population goes on increasing and no net capital accumulation takes place, then the growing population would not be able to get necessary tools, instruments, machines and other means of production with the result that their capacity to produce would be seriously affected.

2) Another important economic role of capital formation is the creation of employment opportunities in the country. Capital formation creates employment as two stages. First, when the capital is produced, some workers have to be employed to make capital like machinery, factories, dams, irrigation works, etc. Secondly, more men have to be employed when capital has to be used for producing further goods.