Capital Formation: Definition, Example, and Why It's Important

Capital Formation

Investopedia / Sydney Saporito

What Is Capital Formation?

Capital formation is 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.

Key Takeaways

  • Capital formation is the net accumulation of capital goods, such as equipment, tools, transportation assets, and electricity, during an accounting period for a particular country.
  • Generally, the higher the capital formation of an economy, the faster an economy can grow its aggregate income.
  • To accumulate additional capital, a country needs to generate savings and investments from household savings or based on government policy.
  • 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.
  • The World Bank tracks gross capital formation, which it defines as outlays on additions to fixed assets, plus the net change in inventories.

Understanding Capital Formation

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.

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.

The higher the capital formation, the faster an economy can grow its aggregate income.

Example of Capital Formation

Caterpillar is one of the largest producers of construction equipment in the world. It produces equipment that other companies use to create goods and services.

CAT 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 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 plants, 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 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 services produced by a country. If a country’s rate of capital formation increases, so does the country’s GDP.

Why Is Capital Formation Important?

Capital formation essentially leads to more money swirling around the economy. The accumulation of capital goods translates to investment and the production of more goods and services, which should boost the income of the population and stimulate demand.

What Factors Affect Capital Formation?

Capital formation doesn’t happen on its own. It depends on the income of the people living in the country and their capacity to save and spend.

What Are the Steps in Capital Formation?

Capital formation occurs when the population has enough income to save and invest. It starts with the creation of savings and is realized when those savings are invested.

The Bottom Line

Capital formation is a key measure of a country’s economic health. Boosting production and investment tends to result in the population becoming better off and having more money to spend, which helps to drive economic growth. In theory, an economy with high capital formation should keep growing, reinvesting its gains to accrue more of them—at least as long as inflation is kept at reasonable levels.

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  1. The World Bank. "Metadata Glossary."