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Capital formation

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Capital formation

  1. 1. Capital Formation:Meaning and Definition:Capital is one of the important factorswhich governs the quantity and thecomposition of output in a country. Ifthere are increasing resources ofcapital in a country, it results intechnological discoveries, raisesproductivity of labor, increases therate of economic development andprovides higher standard of living forthe masses.In case, there is deficiency of capitalassets such as machinery equipmenttools, dams. roads, railways, bridges,etc., etc., the country then remainstrapped in the vicious circle ofpoverty. Capital
  2. 2. accumulation/formation, thus, inbrief is at the vary core of economicdevelopment.It may here be remembered thatthough capital occupies a centralposition, to the process ofdevelopment yet, we cannot ignorethe other factors like education,effective government, social Justice,attitude of the people to work, etc.,etc. These factors play a significantrole in the economic progress of acountry.Economic development is thus amultidimensional phenomenon whichis the result of a combination ofsocial, cultural, political, andeconomic factors. To quote RangerNurkse:
  3. 3. "Economic development has much todo with human endowments, socialattitudes, political conditions, andhistorical accidents. Capital isnecessary but not a sufficientcondition of economic progress".Capital Formation:Capital formation is the process ofbuilding up the capital stock of acountry through investing inproductive plants and equipments.Capital formation, in other words,involves the increasing of capitalassets by efficient utilization of theavailable and human resources ofthe country.
  4. 4. Sources of Capital Formation and Importance:The stock of capital goods can bebuilt up and increased through twomain sources:(1) Domestic Resources and (2)External Resources.(1) Domestic Resources:Domestic resources play animportant part in promotingdevelopment activities in the country.These sources in brief are:(i) Voluntary Savings. There aretwo main sources of voluntarysavings (a) households (b) businesssector. As regards the volume of
  5. 5. personal savings of the households.It depends upon various factors suchas the income per capita, distributionof wealth, availability of bankingfacilities, value system of the society,etc.In the under-developed countries, thesaving potential of the people is lowas a greater number of them sufferfrom absolute poverty. So far as therich section of the, society isconcerned, they mostly spend theirwealth on the purchase of realestates. luxury goods, or take itabroad to safe keeping. There is,therefore very little savingforthcoming from the high incomegroup.
  6. 6. The business sector is an importantsource of voluntary savings in theless developed countries. Theyusually hesitate in assuming the risksassociated with investment. The fearof nationalization and politicalinstability further demands theirincentive to save and invest in thecountry. The statistics of manyunderdeveloped countries indicatethat both these sources hardlymanage to save 15% of their GDP.This is not even sufficient to maintainthe present standard of living of themasses.(ii) Involuntary Savings. In thedeveloping countries, the income percapita of the people is low. Theirpropensity to consume mainly due todemonstration effect is very high. As
  7. 7. the flow of savings is inadequate tomeet the capital needs of thecountry, the government, thereforeadopts measures which restrictconsumption and increase thevolume of savings.The traditional methods used forincreasing the volumes of savingsare (a) taxation (b) compulsoryschemes for lending to thegovernment. The two fiscalmeasures stated above are verysensitive and delicate: They shouldbe devised and handled verycarefully.For instance, if the people of low andmiddle income groups are heavilytaxed through various forms oftaxation, their power, (whatever little)
  8. 8. to save will be burdened with taxes.The tax structure is to be devised insuch a manner that it should provideincentive to work, save and invest forvarious levels of income groups.(iii) Government Borrowing. Thevolume of domestic savings can alsobe increased through governmentborrowing. The government issueslong and short term bonds of variousdenominations and mobilizes savingfrom the genera! public as well asfrom the financial institutions.In the developing countries, there aremany obstacles which stand in theway of governments borrowing. Forinstance, the money and capitalmarket is unorganized. The ruralsector is not provided with adequate
  9. 9. financial institution. People beingilliterate prefer to invest their savingsin gold, jewellery, etc. Thegovernment of developing countriesshould, therefore, evolve a workableprogramme of mobilizing the savingsof the people both in the urban andrural sectors.(iv) Use of Idle Resources. In thedeveloping countries of the worldthere are many resources whichremain unutilized and underutilized. Ifthey are properly tapped anddiverted to productive purposes, therate of capital formation can increaserapidly.For instance, in most of the lowincome countries, there is adisguised unemployment in the rural
  10. 10. sector. If the surplus farmers areemployed at nominal wages in ornear their villages for theconstruction of roads, tube-wells,canals, school buildings, etc., or theirservices are acquired on self-helpbasis for capital creating projects,they can be a valuable source ofcapital formation in the country.(v) Deficit Financing. Deficitfinancing is regarded an importantsource of capita! formation. In thedeveloped countries this method isused for increasing effective demandand ensuring continued high levels ofeconomic activity. In the lessdeveloped countries, it is used tomeet the development and nondevelopment expenditure of thegovernment.
  11. 11. (2) External Resources:External resources has followingtypes:(i) Foreign Economic Assistance.There is a controversy over theimpact of inflow of capital for thedevelopment of a country. It isargued that capital is one of thevariable in the growth process. If thegovernment of a country is ineffectiveand people are not receptive tosocial changes, the inflow of capitalresources and technical assistancewould go waste.In case, the developing nationsneeding foreign capital and technicalassistance have the will to absorb
  12. 12. capital and technical knowledge andthe social and political barriers areovercome, capital then becomes thetouchstone of economicdevelopment. The main benefits ofthe foreign economic assistance,however, in brief are as under:(a) Foreign loans bridge savinggap. In Pakistan, like most of thedeveloping countries, the domesticsaving average 14% of GDP. Thelow rate of saving is not sufficient toachieve the desired rate of growth inthe country. Foreign loanssupplement domestic savings andhelp in bridging the resource gapbetween the desired investment andthe domestic savings.
  13. 13. (b) Close the trade gap. InPakistan, the export earnings arepersistently falling short of importrequirements. The foreign, exchangegap caused by excess ofimport/export is being filled up withinflow of capital.(c) Provides greater employmentopportunities. The financing ofvarious projects with the help offoreign assistance provides greateremployment opportunities in acountry.(d) Increase in productivity ofvarious economic sectors. Theinflow of capital and technical know-how increases the productive capitalof various sectors of the economy.
  14. 14. (e) Increase in real wages. Theforeign resources help in increasingmarginal productivity of labor in therecipient country. The real wages ofthe workers are thus increased withthe help of foreign assistance.(f) Provision of higher products.The foreign capital helps in theestablishment of industries in thecountry. The inflow of technicalknowledge improves the quantity andquality of manufactured goods andmakes them available at lower pricesto the domestic consumers.(g) Increase in tax revenue. Theprofits earned on foreign investmentare taxes by the government; therevenue of the state is thusincreased.
  15. 15. (h) External economies. The inflowof foreign capital and advancedtechnology stimulates domesticenterprises. The firm avails of thebenefits of external economies likethat of training of labor, introductionof new technology, new machinery,etc., etc.(ii) Donor Country and theEconomic Assistance: Here aquestion can be asked .as to why thedeveloped nations are kind in givingaid to the developing countries?According to the rich nations, theforeign aid is given for a combinationof humanitarian and self-interestreasons:
  16. 16. (a) Humanitarian ground. If acountry is faced with famine, drought,epidemic, diseases, earthquake etc.,it is obligatory for the developednations to help that countryfinancially purely on humanitariangrounds. The rich countries areextending economic assistance inthe form of grants to the poor nationsof the world.(b) Self-interest reasons. Foreigneconomic assistance is also providedon the following self interest reasonsby the donor countries.(a) The foreign aid may be given toprotect the developing country fromthe influence of-other campcountries.
  17. 17. (b) The donor country may havesurplus products. In order to checkthe fall in the prices of products in thedomestic market and to maintainlevel of production, the surplus goodsare exported to the needy countrieson loan.(c) Economic assistance is alsoprovided by the. donor countries toremove the economic disparitiesamong the nations of the world.(d) Some advanced nationsparticularly the socialist countriesprovide financial and technical helpfor the propagation of politicalideology in the capitalist developingcountries.
  18. 18. (e) Foreign aid is also given forincreasing the camp followers of thedonor countries.

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