What is Capital Formation
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 stock, such as equipment, tools, transportation assets and electricity. Countries need capital goods to replace the ones that are used to produce goods and services. If a country cannot replace capital goods, production declines. Generally, the higher the capital formation of an economy, the faster an economy can grow its aggregate income.
BREAKING DOWN Capital Formation
Producing more goods and services can lead to an increase in national income levels. In order to add capital stock, 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 stock.
Examples of Capital Stock Production
As an example of the production of capital stock, Caterpillar (CAT) is one of the largest producers of construction equipment in the world, and 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.
How The World Bank Reports 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, while inventory includes works in process, which are partially completed goods that remain in production.
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.