With reference to the 'Capital formation', which of the statements is/are correct? 1. Process of capital formation depends on savings and effectiveness of financial institutions. 2. Investment is the essential factor of capital formation. Select the correct answer using the codes given below.
- (a)Only 1
- (b)Only 2
- (c)Both 1 and 2
- (d)Neither 1 nor 2
Correct — C, both statements. Capital formation is the addition to a country's stock of real productive assets (machines, buildings, infrastructure). It works in three linked stages: (i) generation of savings, (ii) mobilisation of those savings by financial institutions (banks, capital markets), and (iii) their conversion into investment. Statement 1 is right — the volume of capital formed depends on how much a society saves and on how effectively financial institutions channel those savings. Statement 2 is right too — investment, the actual creation of new capital assets, is the essential act of capital formation; savings that are never invested add nothing to the capital stock.
- (a)Only 1 — Statement 2 is also correct: investment is the core act by which savings become new capital goods — it is not an optional extra to the process.
- (b)Only 2 — Statement 1 is also correct: the amount of capital formed depends on the level of savings and on how well financial institutions mobilise them.
- (d)Neither 1 nor 2 — Both statements are standard, textbook descriptions of the capital-formation process — neither can be rejected.
Capital formation (capital accumulation) means increasing the stock of real capital goods in an economy. Economists describe it as a three-stage process: real savings arise when society consumes less than it produces; financial institutions and markets mobilise these scattered savings; and entrepreneurs invest them in creating capital assets. Higher and more efficient capital formation raises productive capacity and long-run growth.
The trap is to treat 'savings' and 'investment' as rivals and pick only one statement. In the capital-formation chain both are indispensable — savings supply the funds, investment does the actual asset creation, and financial institutions are the bridge between them. The two statements describe different, complementary links, so both are correct → (c).
- Capital formation = net addition to the stock of real productive assets
- Three stages: savings → mobilisation by financial institutions → investment
- Savings supply the funds; investment is the act that creates new capital
- A high incremental capital–output ratio (ICOR) lowers the growth payoff of a given amount of capital formation
- Savings (income not consumed)
- Financial institutions mobilise savings (banks, capital markets)
- Investment (creation of capital goods)
- Capital formation (↑ stock of productive assets)
Both statements correct (c): savings + financial institutions feed investment, which is capital formation.
- Treating savings and investment as alternatives and choosing only one statement
- Confusing physical capital formation with human capital formation
Asked as statement-based 'capital formation depends on…' or numerically (savings/investment rate, ICOR, GDCF as % of GDP); recall the savings → mobilisation → investment chain.
Despite being a high saving economy, capital formation may not result in significant increase in output due to
- (a) weak administrative machinery
- (b) illiteracy
- (c) high population density
- (d) high capital-output ratio
Answer(d) high capital-output ratio
Same concept — capital formation and its link to savings and output; even high savings need not raise output if the capital-output ratio is high.
The main reason for low growth rate in India, in spite of high rate of savings and capital formation is
- (a) high birth rate
- (b) low level of foreign aid
- (c) low capital / output ratio
- (d) high capital / output ratio
Answer(d) high capital / output ratio
Same concept — savings and capital formation, and why a high capital-output ratio limits the output they generate.
- practice — not a real PYQ
In the process of capital formation, financial institutions primarily perform which function?
- (a)Producing capital goods
- (b)Mobilising savings and channelling them into investment
- (c)Fixing interest rates by law
- (d)Printing currency
Answer(b) mobilising savings and channelling them into investment.
- practice — not a real PYQ
A high incremental capital-output ratio (ICOR) in an economy indicates that:
- (a)Less capital is needed to produce an extra unit of output
- (b)More capital is needed to produce an extra unit of output
- (c)Savings are automatically very high
- (d)There is no capital formation
Answer(b) more capital is required per extra unit of output — lower capital efficiency.