What is Capital Formation?

Capital formation is a term used to describe the net capital accumulation during
an accounting period for a particular country. The term refers to additions of capital
goods, such as equipment, tools, transportation assets, and electricity. Countries need
capital goods to replace the older ones that are used to produce goods and services. If
a country cannot replace capital goods as they reach the end of their useful lives,
production declines. Generally, the higher the capital formation of an economy, the
faster an economy can grow its aggregate income.

How Capital Formation Works

Producing more goods and services can lead to an increase in national income levels.
To accumulate additional capital, a country needs to generate savings and investments
from household savings or based on government policy. Countries with a high rate of
household savings can accumulate funds to produce capital goods faster, and a
government that runs a surplus can invest the surplus in capital goods.

Example of Capital Formation

As an example of capital formation, Caterpillar (CAT) is one of the largest producers of
construction equipment in the world. CAT produces equipment that other companies
use to create goods and services. The firm is a publicly traded company, and raises
funds by issuing stock and debt. If household savers choose to purchase a new issue
of Caterpillar common stock, the firm can use the proceeds to increase production and
to develop new products for the firm’s customers. When investors purchase stocks and
bonds issued by corporations, the firms can put the capital at risk to increase
production and create new innovations for consumers. These activities add to the
country's overall capital formation.

What Is a Budget Surplus?

A budget surplus occurs when income exceeds expenditures. The term often refers to
a government's financial state, as individuals have "savings" rather than a "budget
surplus." A surplus is an indication that a government's finances are being effectively
managed.

Understanding Budget Surplus

A budget surplus might be used to make a purchase, pay off debt or save for the
future. A city government with a budget surplus may use the money to make
improvements, such as revitalizing a decaying park or downtown area.
KEY TAKEAWAYS

• A budget surplus is when income exceeds expenditures.

• The term "budget surplus" is used in reference to a government's financial
state.

When expenditures exceed income, the outcome is a budget deficit. When

deficits occur, money is borrowed and interest is paid, similar to an individual
spending more than they earn and paying interest on a credit card balance.
A balanced budget exists when expenditures equal income.

Overview
Economic and spending changes generate a surplus. A budget surplus is one indicator
of a healthy economy. However, it is not necessary for a government to maintain a
surplus. The U.S. has rarely run a budget surplus, and has experienced long periods of
economic growth while running a budget deficit. 2 1

A surplus implies the government has extra funds. These funds can be allocated
toward public debt, which reduces interest rates and helps the economy. A budget
surplus can be used to reduce taxes, start new programs or fund existing programs
such as Social Security or Medicare. A budget surplus can occur when growth in
revenue exceeds growth in expenditures, or following a reduction in costs or spending
or both. An increase in taxes can also result in a surplus.

What Is Aggregate Demand?

Aggregate demand is a measurement of the total amount of demand for all finished
goods and services produced in an economy. Aggregate demand is expressed as the
total amount of money exchanged for those goods and services at a specific price level
and point in time.

KEY TAKEAWAYS

• Aggregate demand measures the total amount of demand for all finished
goods and services produced in an economy.
• Aggregate demand is expressed as the total amount of money spent on
those goods and services at a specific price level and point in time.
• Aggregate demand consists of all consumer goods, capital goods
(factories and equipment), exports, imports, and government spending.
Understanding Aggregate Demand
Aggregate demand is a macroeconomic term that represents the total demand for
goods and services at any given price level in a given period. Aggregate demand over
the long term equals gross domestic product (GDP) because the two metrics are
calculated in the same way. GDP represents the total amount of goods and
services produced in an economy while aggregate demand is the demand or desire for
those goods. As a result of the same calculation methods, the aggregate demand and
GDP increase or decrease together.

Technically speaking, aggregate demand only equals GDP in the long run after
adjusting for the price level. This is because short-run aggregate demand measures
total output for a single nominal price level whereby nominal is not adjusted for
inflation. Other variations in calculations can occur depending on the methodologies
used and the various components.

What Is Monetary Theory?

Monetary theory is based on the idea that a change in money supply is a key driver of
economic activity. It argues that central banks, which control the levers of monetary
policy, can exert much power over economic growth rates by tinkering with the amount
of currency and other liquid instruments circulating in a country's economy.

KEY TAKEAWAYS

• Monetary theory posits that a change in money supply is a key driver of

economic activity.
• A simple formula, the equation of exchange, governs monetary theory: MV
= PQ.
• The Federal Reserve (Fed) has three main levers to control the money
supply: the reserve ratio, discount rate, and open market operations.
• Money creation has become a hot topic under the “Modern Monetary
Theory (MMT)" banner.

Understanding Monetary Theory

According to monetary theory, if a nation's supply of money increases, economic
activity will rise, too, and vice versa. A simple formula governs monetary theory: MV =
PQ. M represents the money supply, V is the velocity (number of times per year the
average dollar is spent), P is the price of goods and services, and Q is the number of
goods and services. Assuming constant V, when M is increased, either P, Q, or both P
and Q rise.

General price levels tend to rise more than the production of goods and services when
the economy is closer to full employment. When there is slack in the economy, Q will
increase at a faster rate than P under monetary theory.

In many developing economies, monetary theory is controlled by the central

government, which may also be conducting most of the monetary policy decisions. In
the U.S., the Federal Reserve Board (FRB) sets monetary policy without government
intervention

Monetary Theory vs. Modern Monetary Theory (MMT)

The core tenets of monetary theory have attracted plenty of support under the “Modern
Monetary Theory" (MMT) banner. The likes of Alexandria Ocasio-Cortez and Bernie
Sanders have been championing money creation, describing it as a useful economic
tool, while disputing claims that it leads to currency devaluation, inflation, and
economic chaos.

MMT posits that governments, unlike regular households, should not tighten their purse
strings to tackle an underperforming economy. Instead, it encourages them to spend
freely, running up a deficit to fix a nation’s problems.

The idea is that countries such as the U.S. are the sole issuers of their own currencies,
giving them full autonomy to increase the money supply or reduce the effect of
expansionary monetary policy through taxation. Because there is no limit to how much
money can be printed, the theory argues that there is no way that countries
can default on their debts.

What Is Gross Domestic Product (GDP)?

Gross domestic product (GDP) is the total monetary or market value of all the finished
goods and services produced within a country’s borders in a specific time period. As a
broad measure of overall domestic production, it functions as a comprehensive
scorecard of a given country’s economic health.

Though GDP is typically calculated on an annual basis, it is sometimes calculated on

a quarterly basis as well. In the U.S., for example, the government releases
an annualized GDP estimate for each fiscal quarter and also for the calendar year. The
individual data sets included in this report are given in real terms, so the data is
adjusted for price changes and is, therefore, net of inflation.1

KEY TAKEAWAYS

• Gross domestic product (GDP) is the monetary value of all finished goods
and services made within a country during a specific period.
• GDP provides an economic snapshot of a country, used to estimate the
size of an economy and growth rate.
• GDP can be calculated in three ways, using expenditures, production, or
incomes. It can be adjusted for inflation and population to provide deeper
insights.
• Though it has limitations, GDP is a key tool to guide policy-makers,
investors, and businesses in strategic decision-making.

ypes of Gross Domestic Product

GDP can be reported in several ways, each of which provides slightly different
information.

Nominal GDP
Nominal GDP is an assessment of economic production in an economy that includes
current prices in its calculation. In other words, it doesn’t strip out inflation or the pace
of rising prices, which can inflate the growth figure.

All goods and services counted in nominal GDP are valued at the prices that those
goods and services are actually sold for in that year. Nominal GDP is evaluated in
either the local currency or U.S. dollars at currency market exchange rates to compare
countries’ GDPs in purely financial terms.

Real GDP
Real GDP is an inflation-adjusted measure that reflects the quantity of goods and
services produced by an economy in a given year, with prices held constant from year
to year to separate out the impact of inflation or deflation from the trend in output over
time. Since GDP is based on the monetary value of goods and services, it is subject to
inflation.

Rising prices will tend to increase a country’s GDP, but this does not necessarily reflect
any change in the quantity or quality of goods and services produced. Thus, by looking
just at an economy’s nominal GDP, it can be difficult to tell whether the figure has risen
because of a real expansion in production or simply because prices rose.
GDP Per Capita
GDP per capita is a measurement of the GDP per person in a country’s population. It
indicates that the amount of output or income per person in an economy can indicate
average productivity or average living standards. GDP per capita can be stated in
nominal, real (inflation-adjusted), or PPP (purchasing power parity) terms.

At a basic interpretation, per-capita GDP shows how much economic production value
can be attributed to each individual citizen. This also translates to a measure of overall
national wealth since GDP market value per person also readily serves as a prosperity
measure.

Per-capita GDP is often analyzed alongside more traditional measures of GDP.

Economists use this metric for insight into their own country’s domestic productivity and
the productivity of other countries. Per-capita GDP considers both a country’s GDP and
its population. Therefore, it can be important to understand how each factor contributes
to the overall result and is affecting per-capita GDP growth.

GDP Growth Rate

The GDP growth rate compares the year-over-year (or quarterly) change in a country’s
economic output to measure how fast an economy is growing. Usually expressed as a
percentage rate, this measure is popular for economic policy-makers because GDP
growth is thought to be closely connected to key policy targets such as inflation and
unemployment rates.

If GDP growth rates accelerate, it may be a signal that the economy is “overheating”
and the central bank may seek to raise interest rates. Conversely, central banks see a
shrinking (or negative) GDP growth rate (i.e., a recession) as a signal that rates should
be lowered and that stimulus may be necessary.

GDP Purchasing Power Parity (PPP)

While not directly a measure of GDP, economists look at purchasing power
parity (PPP) to see how one country’s GDP measures up in “international dollars” using
a method that adjusts for differences in local prices and costs of living to make cross-
country comparisons of real output, real income, and living standards.

. On the one hand, an increase in government spending will stimulate aggregate demand and
increase the national income. Correspondingly, a decrease will depress aggregate demand and
reduce national income

in fact, the development and implementation of fiscal policy must be cooperated with the
financial policy, industrial policy and income distribution policy and other economic
policy.
 The important role played by the fiscal policy in a developing economy can be
explained through :

1. Fiscal policy during inflation,

2. Fiscal policy during depression,
3. Fiscal policy and unemployment,
4. Fiscal policy and income inequalities and
5. Fiscal policy and economic growth

Inflation is a period in which the purchasing power with, the people in the economy is high. The
first step to curb inflation is to control the purchasing power with the people. This can be done
using all the tools of fiscal policy. For instance, during inflation, since the private expenditure is
high the government should bring down the public expenditure so that, to that extent the
income generation will be controlled. Alternatively, the government can increase the existing tax
rates or impose new taxes. This will have the effect of taking away the purchasing power from
the rich and well-to-do people thereby curbing the consumption expenditure.

Another way in which the fiscal authorities can function is to indulge in public borrowing. The
government may start borrowing from the people in large scale so that the disposable income
with the people will be reduced bringing down the demand and prices. If voluntary lending is
not effective, then the government may resort to involuntary lending or compulsory saving by
the people. Through its debt management policy also the fiscal authorities can control inflation.
The anti-inflation debt management requires the retirement or payment of bank-held securities
or debts through budgetary surplus. But this is very difficult in practice as in a developing
country the government cannot have budgetary surplus.

Fiscal policy plays a vital role in generating employment opportunities in the developing
countries. In a developing economy, it should aim at solving the problem of both cyclical
unemployment and disguised unemployment. While the former is of temporary nature, the
latter has the snow-balling effect. The latter refers to a situation in which more than the required
number of people are employed in a job. In other words, by reducing the excess of labor from
that job, the productivity or production will not be affected. Hence, it has been found that fiscal
policy alone cannot solve this problem of unemployment in a developing economy. It has to be
coupled with monetary policy. For instance, during inflationary period, the government should
adopt surplus budget, along with hard money policy, while during depression, deficit budget
should be combined with cheap money policy
The role of fiscal policy in removing income inequalities in a developing economy cannot be
exaggerated. With public expenditure and taxation, the government can very easily achieve
income equality. The government should devise its public expenditure scheme by focusing on
the poor and down-trodden people in the society. It may provide cheap food, cheap cloth,
subsidized housing, free medical aid, free education, etc., to the poor people thereby raising
their standard of living. For this purpose, the government should raise funds by imposing taxes
on the rich people so as to bring down their purchasing power. It may completely or partially
relieve the poor people from the tax net. This has the effect of-taking away as much as possible
from the rich people and spending on poor people

Economic growth calls for the application of all the tools of fiscal policy. In developing economy,
there may be no shortage of real or physical resources, but there may be a severe shortage of
financial resources which are required to utilize the physical resources. The object of fiscal
authorities should be to mobilize much funds as possible so as to carry out large scale public
projects. A very effective method of mobilizing financial resources is taxation. The government
can resort to both the direct as well as indirect taxes so as to generate as much funds as
possible from all those who have the ability to pay. Different type of direct taxes and indirect
taxes may be levied to cover every section of the population. There can be specific taxes to curb
certain consumption activities. Another instrument available is public debt. A

Deficit Financing
Deficit financing is understood in different ways in different countries. It is understood
as the excess of current expenditure over current revenue which is financed either through
public borrowing or the creation of new money by the government. So the deficit
budget is also called deficit financing in USA. But in India deficit financing is
understood in a different way from deficit budget. While the former refers to a situation
where the current expenditure exceeds current revenue of the government, the latter is
taken to mean the excess of aggregate expenditure (both on current and capital
accounts) over aggregate revenue. The former is called deficit budgeting and the latter
deficit financing in India.

Inflation has to be controlled, otherwise the extent of damage done to the economy will be
something substantial and the economy would take a long time to recover from the effects of
inflation. In this direction of control of inflation, the following are the theoretical measures
available. These measures could be classified into three groups viz. Monetary measures, Fiscal
measures and Other measures.

Meaning of Stagflation
The present day inflation is the best explanation for stagflation in the whole world. It is
inflation accompanied by stagnation on the development front in an economy. Instead of
leading to full employment, inflation has resulted in un-employment in most of the
countries of the world. It is a global phenomenon today. Both developed and developing
countries are not free from its clutches. Stagflation is a portmanteau term in macro
economics used to describe a period with a high rate of inflation combined with
unemployment and economic recession. Inflationary gap occurs when aggregate demand
exceeds the available supply and deflationary gap occurs when aggregate demand is less
than the aggregate supply. These are two opposite situations. For instance, when inflation
goes unchecked for some time, and prices reach very high level, aggregate demand
contracts and a slump follows. Private investment is discouraged. Inflationary and
deflationary pressures exist simultaneously. The existence of an economic recession at the
height of inflation is called ’stagflation’.

Role of Fiscal Policy in Developing

Countries
The fiscal policy in developing countries should apparently be
conducive to rapid economic development. In a poor country, fiscal
policy can no longer remain a compensatory fiscal policy. It has a
tough role to play in a developing economy and has to face the
problem of growth-cum-stability.
1. Resource Mobilization:
Owing to acute poverty, the marginal propensity to consume is very
high in developing economies. As a result the level of saving is very
low in these economies. Therefore fiscal policy has an important role
to play in mobilizing saving for capital formation through taxation and
public borrowing.

2. Development of Private Sector:

In a developing economy private sector forms an important constitu-
ent of the economy. The production and productivity of private sector
can be influenced by fiscal policy.

Tax relief, rebates, subsides may be granted to boost up the productive

activity in the private sector. Fiscal tools and measures can be used to
activate capital market to ensure availability of adequate resources for
the private sector

3. Optimization of Resources Allocation:

In developing economies, fiscal tools can be utilized to effect optimum
allocation of resources. Very often resources in private sector are
directed towards the production of goods which cater to the re-
quirement of richer section of society.

Fiscal tools can be employed to allocate the mobilized resources in

desirable channels of investment. That is to divert resources from less
useful production to socially necessary lines of production.
Reallocation of resources can be determined according to well defined
priorities of plan. Thus process of reallocation can be done by various
tax incentive measures and subsidy programmes.

4. Creation of Social and Economic Overheads:

In developing economics there is the lack of the proper development
of basic infrastructure which are vital requirements for economic de-
velopment. Provision of social overheads like education and health
service will directly enhance the productive capacity of the people.

Building of social and economic overheads requires lumpy

investments which can never be expected from the private sector,
since they are not profit induced. Hence government has to provide
these investments through fiscal measures of taxation and expenditure
programmes.

Government has also to invest considerable amount of resources to

provide such basic facilities in the agricultural sector, such as irriga-
tion network, subsidized inputs, infrastructure facilities for marketing
to enhance agricultural production and productivity.

5. Balanced Regional Development:

Developing economies face the problem of regional imbalance in the
matter of economic development. Private investments usually con-
centrate in urban area where critical infrastructures are easily ac-
cessible and better marketing facilities are available.

Therefore governmental intervention in the process of decision mak-

ing relating to investment location is imperative for achieving bal-
anced regional development and growth. Therefore government can
set up public sector production in backward area for achieving bal-
anced development.

Fiscal tools like tax concession, tax holiday, subsidies, concessions in

infrastructure utilization etc., can be given to private investors to
attract private investment in these backward geographical areas as
part of the strategies for balanced growth.

6. Economic Stability:
Fiscal tools such as taxation and expenditure programmes can be
utilized as an effective tool to control cyclical fluctuations arising
during the process of economic development. Taxation is an effective
instrument to deal with inflationary and deflationary situations.

The tax structure should be devised which will automatically coun-

teract economic disturbance as and when they occur. Moreover tax
should be flexible enough to make adequate changes in the tax system
according to the prevailing situations. The system should be based on
the principle of progression.

The expenditure programme also can be utilized to fight inflation by

varying public expenditure the government can counteract the
inflationary and deflationary situations in the economy.

7. Reduction of Inequality:

Provision of equality in income wealth and opportunities form an

integral part of economic development in developing economics.
Fiscal policy has an important role to play in reducing inequality.

Instruments of taxation must be used as a means to bring about

redistribution of income. The various fiscal measures directed towards
reduction of inequality in income, wealth and opportunity are:
progressive taxation of income and property, imposition of heavy
taxation on luxury goods, tax exemption or concession to commodities
of mass consumption, government expenditure on relief programmes,
and provision of essential commodities at subsidized price through
fair price shops to the poor etc

dvocates that developing economies should frame a well-

structured fiscal policy so as to give maximum emphasis on
measures:
(a) To check actual and potential consumption in order to raise the
rate of investment,

(b) To regulate the flow of purchasing powers in the true spirit of the
economic plan,

ADVERTISEMENTS:

(c) To achieve a proper distribution of income in the society,

(d) To divert resources from consumption,

(e) To investment to provide fiscal incentives to save and invest,

(f) To facilitate transfer of resources from private sector to government

sector and from less desirable lines of production to more desirable
lines of production, and

(g) To reduce regional imbalance in economic development.

Moreover developing economies depend largely on foreign countries

and funding agencies for capital goods and foreign invest tents.
Therefore fiscal measures have to be adopted to safeguard domestic
economy against foreign capital flows.

The domestic economy must be adequately safe guarded against world

economies fluctuations. Thus the role of fiscal policy can be linked to
the driving of a motor vehicle. While driving up a gradient, an increase
in power is needed.

However when the vehicle moves against the national interest it is

necessary to control the supply of powers. It is also necessary to apply
breaks judiciously to ensure that the vehicle does not slip out of
control, but keep on moving. Therefore the national exchequer should
see that the breaks are not pressed so much as to bring the vehicle to a
halt.