What is Capital Formation?

Malcolm Tatum

A term that is commonly employed in the study of macroeconomics, capital formation has to do with additions to the capital stock in a given accounting period. Pioneered by Simon Kuznets during the 1930s and 1940s, the approach is heralded by some financial analysts as an essential way of assessing the true financial picture of a country. Understanding the current rate can help economists understand the status of a national economy, since the figure helps to identify the rate of economic expansion and the incidence of increased output by the country in question.

Businesswoman talking on a mobile phone
Businesswoman talking on a mobile phone

In many instances, this figure is considered to be equal to the sum of several factors. Capital formation has to do with the fixed capital investment within a country, as well as the increase in the value of the various inventories of assets held and the net value of assets that have been loaned to other countries during the period under consideration. This can include the transfer of savings to fund the loans or some other aspect of the economy. Depending on the exact application, the number may allow for depreciation or exclude any write-offs for deductions connected to depreciation.

Among the variations of capital formation, there are a couple of focused applications that are worthy of note. A gross fixed capital formation will exclude any assets that cannot be properly designated as fixed capital assets. Human capital formation is a more recent variation that focuses on the inclusion of human labor, talents, skills, and the resources that are utilized to train new labor to replace retirees.

While many economists consider this approach to be an important method of understanding the state of the national economy, others question the value of the process. Often, such issues as price inflation, consumption of fixed assets, and the fact that the sales of one domestic entity also happens to be the investment of another entity are cited as important factors that are not involved in calculating the figure. However, supporters maintain that these and other elements can be accounted for by subjecting the capital formation to other formulas to present a broader picture of the economy.

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