Saving and Investment in Open Economy, Macro Economics | Macro Economics - B Com PDF Download

1. Meaning of Capital Formation

In an economy, adequate availability of capital formation is considered as one of the important factors for the overall growth and development of the economy. Inadequate availability or lack of capital formation in the economy may lead to underdevelopment of the economy. Therefore, capital formation is considered as one of the important drivers of growth in the economy. Capital Formation is nothing but the transfer of savings from households and governments to the business sector, resulting in increased output and economic expansion.

Capital formation increases the real capital in the economy which in turn increases the productive capacity or potential of the society. The basic characteristic feature of capital is that it helps to enlarge the productive potential of the economy mainly by adding to the existing stock of capital goods such as machine, tools, plant and machinery, equipment, transport facilitates, land and building, furniture and fixtures etc.

There exists a close and positive relationship between the process of capital formation and economic growth of the economy. In theory, it has been emphasized that a high rate of capital formation is usually accompanied by a rapid growth in productivity and income. Since capital formation or capital accumulation is considered as essential in increasing the economy’s growth and income it is important to determine the rate of capital formation and at the same time it is necessary to understand the important determinants and process of capital formation in the economy.

In an economy the process of physical capital formation can be expressed as a function of following factors or variables: (1) an increase in the volume of real domestic savings so that the resources that would have been used for consumption are released for investment, (2) the creation of adequate banking and financial institutions to mobilize savings of the economy and (3) the emergence of an entrepreneurial class which can utilize the economy’s saving into productive channels of investment.

Therefore, the growth of output of any economy depends on capital accumulation, and capital accumulation requires investment and an equivalent amount of saving to match it. Two of the most important issues in developing economies are how to stimulate investment, and how to bring about an increase in the level of saving to fund increased investment

2. Meaning of Saving and Investment

Saving is defined as personal disposable income minus personal consumption expenditure. In other words, income that is not consumed by immediately buying goods and services is saved. Other kinds of saving can occur, as with corporate retained earnings (profits minus dividend and tax payments) and a government budget surplus.

Investment is the production per unit time of goods which are not consumed but are to be used for future production. At any period of time the stock of capital includes all assets associated with productive capacity such as factories, machinery, plant and equipment, inventories. These assets represent postponed consumption that is; people invest in assets because they expect these assets to deliver goods and services in the future. Therefore, investment is the flow into this stock of capital goods and thus, investment is nothing but is the addition, over some time period, to the real capital stock. In other words, capital is a stock which is measured at a point in time where as investment is flow over a period of time which augment the stock of capital and add to the overall productive capacity.

In measures of national income and output, gross investment (represented by the variable I) is also a component of Gross domestic product (GDP), given by GDP = C + I + G + X, where C is consumption, G is government spending, and X is exports. Thus investment is everything that remains of production after consumption, government spending, and exports are subtracted. Here both non-residential investment such as factories and residential investment such as new houses combine to make up overall investment I. Net investment deducts depreciation from gross investment. It is the value of the net increase in the capital stock per year.

3. Types and Determinants of Domestic Saving

There are basically three types of private domestic saving, each with their own different determinants, namely: voluntary saving; involuntary saving and forced saving. Voluntary saving relates to the voluntary abstinence from consumption by private individuals out of personal disposable income and by companies out of profits.

Involuntary saving is saving brought about through involuntary reductions in consumption. All forms of taxation and schemes for compulsory lending to governments (including national insurance contributions) are forms of involuntary saving.

Forced saving is saving that comes about as a result of rising prices and the reduction in real consumption that inflation involves if consumers cannot defend themselves. Rising prices may reduce real consumption for a number of reasons. Firstly, people may suffer money illusion. Secondly, they may want to keep constant the real value of their money balance holdings, so they accumulate more money and spend less as prices rise. Thirdly, inflation may redistribute income to those with a higher propensity to save, such as profit earners.

Savings in general depend on the capacity to save and the willingness to save. The capacity to save depends on three main determinants: the level of per capita income; the growth of income, and the distribution of income. The willingness to save depends, in turn, on: the rate of interest; the existence of financial institutions; the range and availability of financial assets, and the rate of inflation.

4. Trends of Savings and Capital Formation in India

The central statistical organization (CSO) has been preparing estimates of saving and capital formation as part of National Accounts Statistics in India.

While preparing the estimates of capital formation, the economy is divided into three sectors viz., the household sector which comprises productive economic units either run on an individual basis or partnership or unincorporated business, the private or the corporate sector which includes the joint stock companies and the public or the government sector which includes the capital assets of the government as also the assets of the enterprises run under state control. If we sum up the net change in the value of the assets in a given period in these sectors, we arrive at a total of net domestic capital formation. To this if we add the net inflow of foreign capital we arrive at an estimate of the net national capital formation for the economy.

For this purpose, the estimate is compiled by the type of capital goods i.e., construction and machinery and equipment. This part of capital formation is called fixed capital formation. Estimates of change of stock i.e., working capital are added to gross fixed capital to arrive at the total of gross capital formation.

While preparing the estimates of saving, the economy has been divided into three broad sectors viz., the public sector, the private corporate sector, and the household sector. The public sector comprises public sector undertakings along with departmental enterprises. The private corporate sector limits itself to the organized corporations run under company form of ownership and management. The household sector is a residual sector comprising all economic units other than the nits of public sector and private sector. Thus, the household sector includes besides individuals, all non-government and non-corporate enterprises like sole proprietorships, partnerships and non-profit institutions which furnish educational, health, cultural, recreational and other social and community services to households.

Gross Fixed Capital Formation (GFCF) includes investments in fixed capital goods such as construction, machinery and equipment, plant and machinery etc. The aggregate Gross Domestic Capital Formation (GDCF) is estimated for the entire economy for each year by adding the GFCF and change in stocks. From the total of GDCF estimated, the independently estimates for the gross capital formation for the public sector and private sector are deducted to obtain the residual investment in the household sector.

Aggregate or the Gross Domestic Savings is derived as the sum of the domestic savings of different individual sectors plus foreign savings (i.e., net capital inflow from abroad).

Gross Domestic Savings as a percentage of GDP

Table 4 presents the Sector-Wise Gross Domestic Savings (GDS) as a percentage of GDP in India. As can be observed form the table, that GDS as a percentage of GDP has increased from 8.9 per cent in 1950-51 to 14.6 per cent in 1970-71 to reach a level of 23.1 per cent in 1990-91. By the end of 2004-05, the percentage of GDS to GDP was around 29.1 per cent.

Public sector savings which were 1.8 per cent of GDP in 1950-51 increase to 3.4 per cent in 1980-81. However, thereafter it declined to 1.1 per cent in 1990-91 and became negative in 1998-99 and deteriorated further to -1.9 per cent in 2002-03. This is mainly due to dis-saving in the government sector, as the public sector enterprises have shown a distinct improvement in their performance during 1990-91 to 2002-03. The situation has improved and by the end of 2004-05 the savings accounted for 2.2 per cent of GDP.

The private corporate sector contributed 0.9 per cent pf GDP to GDS in 1950-51 and subsequently its share improved to 2.7 per cent in 1990-91 and it has further shown an improvement and contributed nearly 4.9 per cent to GDS by the end of 2004-05.

Table 4: Sector-Wise Gross Domestic Savings (GDS) as a percentage of GDP in India

(As a percentage of GDP at market prices)
 

Source: CSO, National Accounts Statistics, 2006

Note: 1. Ratios of individual sectors may not add to total because of rounding off.

The household sector contributed 6.2 per cent to GDS in 1950-51 and its share markedly improved to 19.3 per cent of GDP in 1990-91 and it further reached a level of 22 per cent by the end of 2004-05. Thus, from Table 4, it is clearly evident that out of the three sectors, the contribution of household sector to total GDS of the Indian economy was significant.

Gross Domestic Capital Formation as a percentage of GDP

Gross domestic capital formation (GDCF) of India as a percentage of GDP is shown in Table 5. The GDCF was 8.7 per cent of GDP in 1950-51, which increased to 20.3 per cent by 1980-81. Further, it increased to 26.3 per cent in 1990-91, and improved to 26.9 per cent in 1995-96 and thereafter, it increased further to 33.8 per cent in 2005-06.

Table 5: Gross Domestic Capital Formation (GDCF) as a percentage of GDP in India

(As a percentage of GDP at market prices)

Source: CSO, National Accounts Statistics, and Economic

Survey (2006-07)

Note: 1. P indicates provisional and QE indicates quick estimates

Mobilization of the Domestic Saving

In order to achieve the desired savings and investment rates, there would be need to raise large resources domestically. Today, India has a reasonably high and growing savings rate. However, for meeting the financing requirements of a growing economy what is important is mobilization of financial savings and this can be done by channeling the savings in the form of both financial and physical savings.

In India, households undertake savings in the form of both financial as well as physical savings. Financial savings include currency and bank deposits, shares and debentures, life insurance, provident fund and pension funds, etc. Physical savings are mainly in the form of construction of houses, and equipment possessions of households.

Table 6 shows the composition of financial and physical savings of the household sector of India. In 1950-51, due to underdeveloped capital and money market in India the share of financial savings in the total household savings was only 0.6 per cent of GDP and bulk of savings were undertaken in the form of physical assets. However, the situation changed by 1980-81, where the financial savings as a proportion of total savings accounted for 43.5 per cent of total household savings. This was mainly due to the rapid expansion of banking sector in rural as well as urban areas, nationalization of banks, and a large increased of employment in the organized sector which started contributing towards provident funds and pension. The mobilization of rural savings towards Life Insurance Corporation also added to the growth of financial savings. 

Table 6: Composition of Household Savings in India

(As a percentage of GDP at current prices)

Source: EPW Research Foundation (2002)

With the development of capital markets, especially, after financial liberalization, the households began investment in shares and debentures and this further strengthened the share of financial savings in total household savings. In 2004-05, out of the total household savings as a per cent of GDP, the share of financial savings was around 10.3 and that of physical savings was 11.7 per cent.

In order to facilitate substitution of physical savings in favour of financial savings, there would be need for innovative and attractive financial instruments. Appropriate instruments should also be available for the generation of longer term savings that are needed for financing infrastructure. Financial markets, therefore, would have a crucial role to play in mobilizing resources of the required nature.

Gross Domestic Capital Formation by Industry-Wise

The economy is broadly classified into three sectors viz., Agricultural and Allied activities, Industrial sector and Services sector. The composition of gross domestic capital formation by industry-wise is shown in Table 7.

Table 7: Composition of Gross Domestic Capital Formation in India

(As a percentage of total GDCF at 1999-00 prices)

Source: EPW Research Foundation (2002)

As can be seen from the Table 7, that the percentage share of manufacturing sector in total GDCF has increased to about 34.8 per cent by the end of 2004-05 from 19.2 per cent in 1950-51 where as the percentage share of agriculture, forestry and fishing in total GDCF has declined to 7.8 per cent in 2004-05 from 19.3 per cent in 1950-51. over the years, industries in services sector such as trade, hotels and restaurants, transport, storage and communication, finance, insurance, real estate and business services and community, social and personal services have also contributed a major proportion of total GDCF in India.