Previous Year Question
With reference to the ‘Capital formation’ which of the statements is/are correct?
Process of capital formation depends on savings and effectiveness of financial institutions.
Investment is the essential factor of capital formation.
Select the correct answer using the codes given below.
Codes:
Only 1
Only 2
Both 1 and 2
Neither 1 nor 2
Correct Answer: C
Detailed Solution
Statement 1 is correct. The process of Capital Formation first requires the creation of savings in the economy. The portion of income that is not spent on current consumption becomes saving.
However, savings alone are not sufficient. Banks, financial institutions and financial markets play an important role in transferring these savings towards productive investment.
The process can be understood simply as—
Income → Saving → Mobilisation of Savings → Investment → Capital Formation
Financial institutions mobilise savings from households and other savers and channel them to businesses and investors requiring capital for productive activities. Therefore, the effectiveness of financial institutions influences how efficiently savings are transformed into productive investment.
Statement 2 is also correct. Investment is an essential component of capital formation. Merely saving money does not automatically create productive capital. When savings are used to create machinery, plant, equipment, buildings, infrastructure or other productive assets, the capital stock of the economy increases.
Thus, the broad process of capital formation involves three important stages—
1. Creation of Savings
2. Mobilisation of Savings
3. Conversion of Savings into Productive Investment
If savings exist but are not invested, the productive capital stock will not increase accordingly. Similarly, adequate savings and effective financial intermediation are important for sustaining investment.