Capital formation or capital formation is the expansion or accumulation of capital and capital goods (such as equipment, machines and buildings) that produce other goods and services. This expansion ultimately leads to higher economic growth.
Description of “Capital Formation”
A company or economy needs capital goods to increase production or replace old capital goods. Capital goods are important for producing goods and services. For example, if replacements are not made when a machine has reached the end of its useful life, production will decline.
Additional capital requires investment. And, the investment must be greater than the depreciation value (in other words positive net investment). That way, capital investment not only replaces old equipment, but also adds new equipment.
Say, a company buys a machine for IDR 100 million. The machine is capable of producing 10 thousand units of product X and can produce up to 10 years (depreciation per year is around 10 million, using the straight line method). Assuming the machine price remains the same, no later than the tenth year, the company must invest IDR 100 million to maintain its current production.
If the company wants to double its production, the investment must be IDR 200 million. That way, the company can replace one old machine and add one new machine. In this case, the net investment value issued by the company is IDR 100 million.
Relation to economic growth
In general, the higher an economy’s capital formation, the higher its economic growth (measured by real GDP growth). To accumulate capital goods, a country must generate savings and investments. These savings can come from households and businesses (private savings) and from the government (public savings).
Household savings later flow into financial markets, where companies can use them to purchase capital goods. Meanwhile, government savings exist when running a fiscal surplus, which is where there is income remaining after paying all expenses. The remaining money can be invested in capital goods such as infrastructure and utilities.