Gross Capital Formation

Gross capital formation is the total investment in fixed assets and in inventories by the economy during a period, before the deduction of consumption of fixed capital. It is a component of gross domestic product and a key measure of investment activity.

Components

Gross capital formation comprises gross fixed capital formation, which is investment in fixed assets including machinery, buildings, and infrastructure, and changes in inventories, which measure the increase or decrease in stocks of goods held by firms.

Gross fixed capital formation is the larger component in most economies. It includes investment by firms, by governments, and by households, and it covers both new assets and improvements to existing assets. It excludes financial investment, which is a transfer of claims rather than the creation of real assets.

Changes in inventories capture the difference between production and sales during the period. An increase in inventories represents investment, since goods that are produced but not sold are held as an asset. A decrease in inventories represents disinvestment.

Measurement

The measurement of gross capital formation requires data on investment expenditure and on changes in inventories. The data are collected from surveys of firms and from administrative records, and they are adjusted for coverage and for valuation.

The measurement of inventories is particularly difficult, since it requires information about the quantity and the value of stocks. The data are often based on accounting records that may not be consistent with the national accounts concepts.

Valuation also matters. Gross capital formation is valued at purchasers' prices, which include taxes and transport costs. Changes in inventories are valued at basic prices, and the adjustment for holding gains and losses is required, since a change in the value of inventories may reflect a price change rather than a change in quantity.

Economic Significance

Gross capital formation is a key determinant of the productive capacity of the economy. Investment adds to the capital stock, which, together with labour and technology, determines the potential output of the economy. The rate of investment is therefore a central determinant of growth.

The composition of investment matters as well as its level. Investment in machinery and equipment tends to embody new technology and to raise productivity, while investment in buildings has a longer life and a slower effect. The composition affects the growth effects of a given level of investment.

Gross capital formation is also a component of aggregate demand, and fluctuations in investment are an important source of fluctuations in output. Investment is more volatile than consumption, and it tends to fall sharply during downturns, amplifying the cycle.

Policy

Policy affects gross capital formation through several channels. The cost of capital, which reflects interest rates and the tax treatment of investment, affects the incentive to invest. Access to finance, which depends on the development of financial markets, affects the ability to invest.

Public investment also contributes to gross capital formation and can complement private investment by providing infrastructure and by raising the return to private capital. The design of public investment and its financing are therefore relevant to the analysis of growth.

Investment and Growth

Investment is a central determinant of growth, since it adds to the capital stock and embodies new technology. The relationship between investment and growth has been documented across countries and over time, and it is a central element of growth models.

The direction of causation is debated. Investment may raise growth, but growth may also raise investment, since firms invest in response to expanding markets. The two are mutually reinforcing, and the identification of the effect of investment on growth is complicated.

The composition of investment affects its contribution to growth. Investment in machinery and equipment tends to embody new technology and to raise productivity, while investment in buildings has a longer life and a slower effect. The quality of investment also matters, since poorly chosen projects may yield low returns.

Financing of Investment

The financing of investment depends on the availability of internal funds and of external finance. Firms with strong cash flows can finance investment internally, while firms with limited internal funds must raise external finance.

The development of financial markets affects the availability of external finance. Countries with deeper financial systems tend to have higher rates of investment, since firms can obtain funds more easily. The relationship between finance and investment is one of the channels through which financial development affects growth.

The cost of finance also matters. A higher cost of capital reduces the incentive to invest, particularly for projects with long payback periods. The design of tax policy affects the after-tax cost of capital and thereby the incentive to invest.

Public and Private Investment

The distinction between public and private investment is important for the analysis of policy. Public investment provides infrastructure and other assets that raise the productivity of private capital, while private investment adds to the productive capacity of firms.

Public investment can crowd out private investment, by competing for resources and by raising interest rates, or it can crowd in private investment, by raising its return. The net effect depends on the state of the economy and on the design of the investment.

The design of public investment affects its effectiveness. Projects that are well chosen and well implemented have higher returns, while poorly chosen projects waste resources. The institutional framework for the appraisal and the management of projects therefore matters for the contribution of public investment to growth.

Summary

Gross capital formation is a key determinant of growth and a component of aggregate demand, and its measurement and its analysis inform the understanding of investment and of the economy. The financing of investment, the composition of investment, and the relationship between public and private investment all shape its effects.

See also

• Capital Consumption
• National Accounts
• Gross Capital Formation