Economics Class

Savings, Investment and Capital formation*


Define: Savings and Investment. Discuss the relationship between the two.


Savings is that part of the income which is not spent on consumption.

Savings= Income- Consumption

S            = Y            - C

Investment refers to the net increase in the stock of real capital. It is that part of the income which is spent to add to stock of real capital.

Investment= Income- consumption, assuming that entire savings is invested.

I                   = Y             - C

When income increases, savings increase, when savings increase investment also increases. Savings and investment although do not increase proportionately.

Therefore, more savings means more investment, which implies increase in production, which leads to more demand for factor inputs,which results in more income, which implies more demand, that leads to more investment, leading to rapid economic growth, this again leads to increased savings, and the whole process is cyclical.                                                                                                                                                                                                                                                                                                                                                                    
Define: propensity to save and consume.


Propensity to save is the ratio between income and savings. When income increases, savings also increase, but not proportionately.

Average propensity to save= savings/income

Propensity to consume is the ratio between income and consumption. When income increases, consumption also increases, but not proportionately.

Average propensity to consume= consumption/income



What is capital formation? Discuss its importance in economic growth.


Capital formation refers to adding to the capital stock of a country. It is surplus production over consumption.

Capital formation= domestic savings+ net inflow of funds from abroad

Capital formation is necessary for economic growth. Its importance can be discussed as follows:

v  It enables establishment of industries which require heavy capital investment and are basic in nature.

v  Large capital stock enables the country to make use of latest techniques of production.

v  With the help of large capital stock, a country acquires the capacity to change, innovate and adjust to new ideas and technological advances.



Your Ad Here

What are the components of capital formation? (Gross domestic fixed capital formation)


Components of capital formation are:

a.      Gross fixed capital formation (GFCF)

                                                                                i.            Construction of residential and non-residential buildings.

                                                                              ii.            Other constructions, including land improvement, plantation and orchard development.

                                                                            iii.            Transport equipment.

                                                                             iv.            Machinery and other equipment.

                                                                               v.            Breeding stocks, draught animals, dairy cattle, and other livestock.

b.      Increase in stock or changing stock

                                                                                i.            Unutilized raw materials.

                                                                              ii.            Unsold goods.

                                                                            iii.            Semi- finished goods.

                                                                             iv.            Stock of strategic and other important materials held by government. Example: buffer stock of food grains, arms, etc.

                                                                               v.            Livestock, except breeding stock.


What is incremental capital output ratio?


The ratio of gross domestic fixed capital formation (GDFCF) to the increase in gross domestic product (GDP) is termed as incremental capital output ratio (ICOR).

Example: if gross investment is Rs. 30,000 crore and increase in GDP is Rs. 6,000 crore, then

ICOR= Rs. 30,000 crore/Rs. 6,000 crore= 5:1



What is the problem of capital formation?


The problem of capital formation is the choice between present consumption and saving for the future. A developing economy has to decide whether it has to remain content with the present level of consumption or has to raise it in future. If it is the second case, then it has to save and invest to increase its capital stock.



What are the various sources of savings? (Domestic savings)


Sources of domestic savings are:

                                i.            Public Sector: it includes central government, state government, local authorities, etc. It Sources of savings: tax revenue and savings of public sector enterprises.

                              ii.            Private Corporate Sector: it includes banks, private companies, co- operative institutions, etc.

Source of savings: profit of these institutions

                            iii.            Household Sector: it includes rural and urban households, non- profit making institutions, etc.

Source of savings:

·         Physical assets: fixed investments in agriculture, constructions, etc.

·         Financial assets: currency, deposits, gold, etc.

Income is the major source of savings in household sector.