Increasing Productivity And Economic Growth (Guide)

Productivity is the cornerstone of the wealth of nations. Productivity also affects competitive position: the more productive a nation is, the better for them to be able to compete on world markets. In short, productivity is the source of the high standard of living enjoyed by developed economies relative to third world or to the same economies fifty or one hundred years ago.

Increase in productivity allow firms to produce greater output for the same level of input, and thus result in higher Gross Domestic Product. Economic growth has traditionally been attributed to the accumulation of human and physical capital, and increased productivity arising from technological innovation.

Economic growth is the increase in the inflation-adjusted market value of the goods and services produced by an economy over time. It is conventionally measured as the percent rate of increase in real gross domestic product, or real GDP. GDP growth caused only by increases in the amount of inputs available for use (increased population, new territory) is called extensive growth.

A study of agriculture in Thailand and Indonesia by Warr (2006) shows that, between 1981 and 2002, productivity increases in the sector following the introduction of irrigation accounted for 5% of overall GDP growth in Thailand and 3.5% in Indonesia. Moreover, the productivity increases in agriculture freed up resources which could then be put to use in other sectors. 

This reallocation contributed 16% to overall GDP growth in Thailand and 24% in Indonesia. A global review by ILO (2013) examines the impact of labour productivity on growth. It finds that increase in labour productivity within economic sectors is the main driver of economic growth. In particular, growth in industry and services play an important role for aggregate economic growth including;

Increase in labor productivity (the ratio of the value of output to labor input) have historically been the most important source of real per capita economic growth.

Increases in productivity lower the real cost of goods. Over the 20th century the real price of many goods fell by over 90%.

Increase in productivity is the major factor responsible for per capita economic growth – this has been especially evident since the mid-19th century. 

Most of the economic growth in the 20th century was due to reduced inputs of labor, materials, energy, and land per unit of economic output (less input per widget). The balance of growth has come from using more inputs overall because of the growth in output (more widgets or alternately more value added), including new kinds of goods and services (innovations).

During the Industrial Revolution, mechanization began to replace hand methods in manufacturing, and new processes streamlined production of chemicals, iron, steel, and other products. Machine tools made the economical production of metal parts possible, so that parts could be interchangeable.

Similarly, at the cause of the Second Industrial Revolution, a major factor of productivity growth was the substitution of inanimate power for human and animal labor. Also there was a great increase power as steam powered electricity generation and internal combustion supplanted limited wind and water power. 

Since that replacement, the great expansion of total power was driven by continuous improvements in energy conversion efficiency. Other major historical sources of productivity were automation, transportation, infrastructures (canals, railroads, and highways), new materials (steel) and power, which includes steam and internal combustion engines and electricity. 

Other productivity improvements included mechanized agriculture and scientific agriculture including chemical fertilizers, livestock, poultry management, and the Green Revolution. Interchangeable parts made with machine tools powered by electric motors evolved into mass production, which is universally used today.

Moreover, great sources of productivity improvement in the late 19th century were railroads, steam ships, horse-pulled reapers and combine harvesters, and steam-powered factories. The invention of processes for making cheap steel were important for many forms of mechanization and transportation. 

By the late 19th century both prices and weekly work hours fell because less labor, materials, and energy were required to produce and transport goods. However, real wages rose, allowing workers to improve their diet, buy consumer goods and afford better housing. 

Industrialization creates a demographic transition in which birth rates decline and the average age of the population increases thus women with fewer children and better access market employment tend to join the labor force in higher percentages. In recent times, there is also a reduced demand for child labor and children spend more years in school. 

The increase in the percentage of women in the labor force in the U.S. contributed to economic growth, as did the entrance of the baby boomers into the work force. Furthermore, in the supply and demand model, technology that improves productivity creates a shift in the supply curve, meaning that the amount of supply available occurs at lower costs, which increases demand. 

The development of new products and services increases both total supply and demand. In economics and economic history, the transition to capitalism from earlier economic systems was enabled by the adoption of government policies that facilitated commerce and gave individuals more personal and economic freedom. 

These included new laws favorable to the establishment of business, including contract law, the abolishment of anti-usury laws and laws providing for the protection of private property. When property rights are less certain, transaction costs can increase, hindering economic development. 

Enforcement of contractual rights is necessary for economic development because it determines the rate and direction of investments. On the other hand, when the rule of law is absent or weak, the enforcement of property rights depends on threats of violence, which causes bias against new firms because they cannot demonstrate reliability to their customers.

Not having clear legal title to property limits its potential to be used as collateral to secure loans, depriving many less developed countries one of their most important potential sources of capital. Unregistered businesses and lack of accepted accounting methods are other factors that limit potential capital.

On the other hand, businesses and individuals participating in unreported business activity and owners of unregistered property face costs such as bribes and pay-offs that offset much of any taxes avoided. In economics ordinarily refers to physical capital, which consists of structures and equipment used in business (machinery, factory equipment, computers and office equipment, construction equipment, business vehicles, etc.).

Up to a point the amount of capital per worker is an important cause of economic output growth. Capital is subject to diminishing returns because of the amount that can be effectively invested and because of the growing burden of depreciation.

In the development of economic theory the distribution of income was considered to be between labor and the owners of land and capital.

In recent decades however, there have been several Asian countries with high rates of economic growth driven by capital investment.

Another major cause of economic growth is the introduction of new products and services and the improvement of existing products. New products create demand, which is necessary to offset the decline in employment that occurs through labor saving technology.

Economic growth in Nations went through phases that affected growth through changes in the labor force participation rate and the relative sizes of economic sectors. The transition from an agricultural economy to manufacturing, increased the size of the high output per hour, high productivity growth manufacturing sector while reducing the size of the lower output per hour, lower productivity growth in the agricultural sector.

Eventually, high productivity growth in manufacturing reduced the sector size as prices fell and employment shrank relative to other sectors. The service and government sectors, where output per hour and productivity growth is very low, saw increases in share of the economy and employment during the 1990s. The public sector has since contracted, while the service economy expanded in the 2000s.

One ubiquitous element of both theoretical and empirical analyses of economic growth is the role of human capital. The skills of the population enter into both neoclassical and endogenous growth models. The most commonly used measure of human capital is the level of school attainment in a country, building upon the data development of Robert Barro and Jong-Wha Lee. 

This measure of human capital, however, requires the strong assumption that what is learned in a year of schooling is the same across all countries. It also presumes that human capital is only developed in formal schooling, contrary to the extensive evidence that families, neighborhoods, peers, and health also contribute to the development of human capital.

To measure human capital more accurately, Eric Hanushek and Dennis Kimko introduced measures of mathematics and science skills from international assessments into growth analysis. They found that quality of human capital was very significantly related to economic growth. 

This approach has been extended by a variety of authors, and the evidence indicates that economic growth is very closely related to the cognitive skills of the population. Hanushek and Ludger Woessmann expand on the concept of cognitive skills and growth. They define the aggregate skills of a nation as its “knowledge capital” and show that this is robust explanation of differences in long run growth rates. 

In a series of tests, they address whether the relationship of knowledge capital and growth is causal. While not conclusive, they provide evidence that the major concerns about the identification of causal effects do not appear to be driving their results. They show that recognizing the importance of knowledge capital can explain the puzzles of slow growth in less developed nations and the underlying causes of rapid growth in moderately developed and developed nations.

Everyone has his or her own pet theory about what increases productivity and that's as it should be, but one factor that we've seen can be important is the rate of investment: in Japan, for example, a higher rate of investment led to greater growth in the stock of capital.

In addition, education is associated with productivity. As a rule, countries that invest the most in education also tend to be the richest and have the highest rates of growth of per capita output. Note the growth rate effect, not only are countries with more education richer, they also seem to grow faster.

Education has clear benefits to individuals, too. This includes formal schooling, job training, and work experience. A huge number of studies has established that each year of school tends to raise one's wage between 5 and 7 percent, on average. The numbers vary depending on the quality of school, the type of education, and so on, but there's little doubt that more highly educated workers are better.

Another factor underlying productivity growth is invention and innovation narrowly defined---roughly speaking, the men and women in the white lab coats. One way to raise productivity is to spend money on research and development, which many firms do in a big way. Bristol-Myers-Squibb, for example, owes much of its recent success to the development of a new drug for heart patients, a product of generous expenditures on scientific research. 

Corning has grown with new developments of glass technology, like fiber optics. The US, on the whole, is the world leader in pure science (Research).While Japanese are the leaders in development of new technologies. The trick here is to take basic scientific advances and convert them into profitable ventures. By all reports the US is not as good at the second step as it is at the first, while for Japan it's the reverse. 

The main point is that it takes more than Einstein to generate aggregate productivity growth. One of the things you might guess is that firms must invest in new technologies to stay competitive, perhaps by supporting large research laboratories. And that's probably right in some cases. 

But some of the greatest innovations in management and productivity enhancement concern, instead, changes in the ways in which people are organized. Consider your typical acronym with a Q in it: SQC (statistical quality control), TQC (total quality control), QFD (quality function deployment), etc. 

The basic ideas here concern not technology in the narrow sense of scientific breakthroughs, but organizing management and workers to operate more effectively as a team. One of the interesting trends in management philosophy has been toward a greater emphasis on cooperation. At some level the benefits of cooperation are obvious: you should have the quarterback and the wide receiver running the same play.

In modern management, the suggestion is that there must be active cooperation among the entire production team, from assembly line workers on up to the CEO. Most of these methods require active participation by the people on the line to work, since they are the closest to the process and thus know the most (hard as that is for senior management to believe).

Economists, by and large, have come to a conclusion that, competition among firms has been useful. But maybe there should be room for cooperation, too. Example, farmers use combines instead of scythes to harvest grain, and manufacturers use automated assembly lines instead of lines of workers with hammers to produce cars. 

Being able to produce more for less is what separates the businesses that survive, and the economies that boom, from those that fall by the wayside. A society with a highly developed supply chain infrastructure that includes interstate highways, a large railroad network, ports and airports is able to trade many goods at low cost. 

Business and consumers are able to obtain these goods quickly, resulting in economic growth. Supply Chain Management (SCM) is necessary to the foundation and infrastructure within societies. SCM within a well-functioning society creates jobs, decreases pollution, decreases energy use and increases the standard of living.

Clearly, the impact that SCM has on business is significant and exponential. Two of the main ways SCM affects business include:

Boosts Customer Service: SCM impacts customer service by making sure the right product assortment and quantity are delivered in a timely fashion. Additionally, those products must be available in the location that customers expect. Customers should also receive quality after-sale customer support.

Improves Bottom Line: SCM has a tremendous impact on the bottom line. Firms value effective and efficient supply chain managers because they decrease the use of large fixed assets such as plants, warehouses and transportation vehicles in the supply chain. Also, cash flow is increased because if delivery of the product can be expedited, profits will also be received quickly.

Supply Chain Management helps streamline everything from day-to-day product flows to unexpected natural disasters. With the tools and techniques that SCM offers, you’ll have the ability to properly diagnose problems, work around disruptions and determine how to efficiently move products to those in a crisis situation.

A domestic manufacturer boosting productivity could lead to higher wages and higher employment, because it earns more while spending less to produce a good, while the scenario means that the manufacturer will potentially have higher profits with cheaper imports, but won't necessarily need to hire any new employees.

If a domestic manufacturer uses the goods it imports more efficiently and winds up needing to import less, this is treated the same by national statistics as that same domestic manufacturer finding a cheaper source of imports (e.g. using a local supplier instead of a foreign one). While in a pure dollar sense they are the same, they are very much different, when it comes to how they affect the economy as a whole.

Furthermore, productivity increases do not always lead to increased wages. Increases in employment without increases in productivity lead to a rise in the number of working poor, which is why some experts are now promoting the creation of "quality" and not "quantity" in labor market policies.

This approach, does highlight how higher productivity has helped reduce poverty in East Asia. In Vietnam, for example, employment growth has slowed while productivity growth has continued.

However, employment is no guarantee of escaping poverty; the International Labour Organization (ILO) estimates that as many as 40% of workers are not earning enough to keep their families above the $2 a day poverty line. Meanwhile, other countries found bigger benefits from focusing more on productivity improvement than on low-skilled work.

Agriculture provides a safety net for jobs and an economic buffer when other sectors are struggling. The large impact of a relatively small growth rate over a long period of time is due to the power of exponential growth. Thus, a small difference in economic growth rates between countries can result in very different standards of living for their populations if this small difference continues for many years.

The rule of 72, a mathematical result, states that if something grows at the rate of x% per year, then its level will double every 72/x years. For example, a growth rate of 2.5% per annum leads to a doubling of the GDP within 28.8 years, whilst a growth rate of 8% per year leads to a doubling of GDP within 9 years.

GDP has long been considered the best aggregate measure of economic activity we have.

How Does Investment Affect Productivity & Economic Growth?

An economy, grows in only a few specific ways. The most important, consistent and controllable way to grow an economy is through improved capital goods structure and growing capital stock, which is where capital investment comes in.

Investment is a sacrifice, which involves taking risks. This means that businesses, entrepreneurs, and capital owners will require a return on their investment in order to cover this risk, and earn a reward. In terms of the whole economy, the amount of business profits is a good indication of the potential reward for an investment.

A business for example, does not see an immediate increase in revenue when it develops capital goods. To make it economically viable to increase or improve the capital structure, a company must have a pool of saved funds to draw upon. This pool of funds needs to last until the new capital goods lead to additional revenue.

Increased capital investment allows for more research and development in the capital structure. This expanding capital structure raises the productive efficiency of labor. As labor becomes more efficient, more goods are produced (higher gross domestic product) and the economy grows.

Gross domestic product is the economic measure most watched to gauge the economic strength and growth of the nation. Four areas of spending are measured when it comes to the GDP of an economy:
  • Consumer Spending;
  • Investment;
  • Government Spending;
  • Total amount of exports net of imports.

Investment is the most volatile of the four components and is thought to be the best indicator of the direction of an economy. There are three components of investment, as used in figuring GDP. They are business spending, new residential construction and changes in inventory.

Federal Reserve monetary policy affects investment first because, each of the three components relies heavily on bank loans or borrowing via the issue of bonds. Bank loans and bond issuance creates money in the system, adding to the money supply, which fuels economic growth. 

When the Fed wants to slow the growth of the economy it makes borrowing more expensive by raising interest rates and removing money from the system. Likewise, when the economy is in recession, the Fed lowers rates to encourage borrowing. Low interest rates encourage businesses to invest in new plants and equipment and to increase inventory in anticipation of increased buying by other businesses and consumers. 

Real estate developers build new housing in anticipation of demand from consumers reacting to low mortgage rates. Business investment in new facilities, equipment, employment and administrative costs puts money directly into the economy because it uses retained earnings and borrowings from banks and the debt market.

Thus, when a company leases, buys or builds new facilities it transfers a large amount of money to another business, the supplier for those facilities. In turn, the new facilities create a need for work hours of the supplier’s employees, who build, renovate and prepare the new facilities.

The employees hired by the supplier, now have money to spend on consumer goods and new housing. New residential construction is part of GDP because of it's new use of building materials, appliances and utility hook-ups. Sales of existing houses are not part of GDP, but the money spent by consumers to redecorate falls under the consumer spending component, also called consumption. 

It also includes; the money involved in investment by business in facilities, equipment and employees travels throughout the system -- spurring new business investment and new residential building -- and even to the other components of GDP, such as consumer spending. 

It also spurs the import-export trade, as businesses and consumers purchase goods and services manufactured abroad. As business investment creates increased income, governments receive increased revenues from sales taxes and income taxes, and spend it on public works and services.

Similarly, changes in business confidence can have a considerable influence on investment decisions. Uncertainty about the future can reduce confidence, and means that firms may postpone their investment decisions until confidence returns. Changes in national income create an accelerator effect. 

Economic theory suggests that, at the macro-economic level, small changes in national income can trigger much larger changes in investment levels. Increased capital investment allows for more research and development in the capital structure. This expanding capital structure raises the productive efficiency of labor. 

As labor becomes more efficient, more goods are produced (higher GDP) and the economy grows. The level of investment in an economy tends to vary by a greater extent than other components of aggregate demand. This is because the underlying determinants also have a tendency to change.

The Main Determinants Of Investment Are:

Interest rates: Investment is inversely related to interest rates, which are the cost of borrowing and the reward to lending. Investment is inversely related to interest rates for two main reasons.

Firstly, if interest rates rise, the opportunity cost of investment rises. This means that a rise in interest rates increases the return on funds deposited in an interest-bearing account, or from making a loan, which reduces the attractiveness of investment relative to lending. Hence, investment decisions may be postponed until interest rates return to lower levels.

Secondly, if interest rates rise, firms may anticipate that consumers will reduce their spending, and the benefit of investing will be lost. Investing to expand requires that consumers at least maintain their current spending. Therefore, a predicted fall is likely to discourage firms from investing and force them to postpone their investment decisions.

Why Is GDP So Important To Economists And Investors?

The income approach, which is sometimes referred to as GDP(I), is calculated by adding up total compensation to employees, gross profits for incorporated and non incorporated firms, and taxes less any subsidies. The expenditure method is the more common approach and is calculated by adding total consumption, investment, government spending and net exports.

As one can imagine economic production and growth, what GDP represents has a large impact on nearly everyone within that economy. For example, when the economy is healthy, you will typically see low unemployment and wage increases as businesses demand labor to meet the growing economy. 

A significant change in GDP, whether up or down, usually has a significant effect on the stock market. It's not hard to understand why: a bad economy usually means lower profits for companies, which in turn means lower stock prices. Investors really worry about negative GDP growth, which is one of the factors economists use to determine whether an economy is in a recession.

When it comes to economic theory, net investment carries more significance, as it provides the basis for economic growth.

Net investment = gross investment – depreciation

Net investment helps give a sense of how much money a company is spending on capital items used for operations, such as property, plants, equipment and software. Subtracting depreciation from this amount, or capital expenditure (CAPEX) (since capital assets lose value over their life because of wear and tear, obsolescence, etc.), provides a more accurate picture of the investment's actual value.

Capital assets include property, plants, technology, equipment and any other assets that can improve the productive capacity of an enterprise. The cost of capital assets also includes upkeep, maintenance, repair or installation of said assets. The term "capital goods" does not refer to the same thing as financial capital or human capital. 

Financial capital includes the funds necessary to sustain and grow a business (debt and equity), and human capital represents actual human labor. It takes financial capital to invest in capital goods, and it takes human capital to design, build and operate capital goods. If gross investment is consistently higher than depreciation, net investment will be positive, indicating that productive capacity is increasing. 

Conversely, if gross investment is consistently lower than depreciation, net investment will be negative, indicating that productive capacity is decreasing, which can be a potential problem down the road. This is true for all entities, from the smallest companies to the largest economies.

Net investment is therefore a better indicator than gross investment of how much an enterprise is investing in its business, since it takes depreciation into account. Investing an amount equal to the total depreciation in a year is the minimum required to keep the asset base from shrinking. 

While this may not be a problem for a year or two, net investment that is negative for a prolonged time period will render the enterprise uncompetitive at some point. A business does not see an immediate increase in revenue when it develops capital goods. To make it economically viable to increase or improve the capital structure, a company must have a pool of saved funds to draw upon. 

This pool of funds needs to last until the new capital goods lead to additional revenue. Continued investment in capital assets is critical to an enterprise's ongoing success. The net investment amount required for a company depends on the sector it operates in, since all sectors are not equally capital intensive. 

Sectors such as industrial products, goods producers, utilities and telecommunications are more capital intensive than sectors such as and consumer products. Therefore, comparing net investment for different companies is most relevant when they are in the same sector.

Firms Invest For Two Primary Reasons:

Investment may be required to replace worn out, or failing machinery, equipment, or buildings. This is referred to as capital consumption, and arises from the continuous depreciation of fixed capital assets. Otherwise, investment may be undertaken to purchase new machinery, equipment, or buildings in order to increase productive capacity. 

This will reduce long-term costs, increase competitiveness, and raise profits. Gross investment includes both types of investment spending, but net investment only measures new assets rather than replacement assets.

What Drives Long-Run Economic Growth?

Growth accounting measures the contribution of each of these three factors to the economy.
  • Accumulation of capital stock;
  • Increases in labor inputs, such as workers or hours worked;
  • Technological advancement.

As a result, a country cannot maintain its long-run growth by simply accumulating more capital or labor. Therefore, the driver of long-run growth has to be technological progress. Per capita output growth is first broken down into the respective contributions from capital stock, labor inputs and technological advancements.

Therefore an increase in GDP is the increase in a country’s production. Growth doesn’t occur in isolation. Events in one country and region can have a significant effect on growth prospects in another. For example, if there’s a ban on outsourcing work in the 

United States, this could have a massive impact on India’s GDP which has a robust IT sector dependent on outsourcing. Economic growth is one of the most important indicators of a healthy economy. One of the biggest impacts of long-term growth of a country is that it has a positive impact on national income and the level of employment, which increases the standard of living.

As the country’s GDP is increasing, it is more productive which leads to more people being employed. This increases the wealth of the country and its population. Economic growth does not only helps improve the standards of living but also reduce poverty, but these improvements cannot occur without economic development.

Some Other Factors That Affect Economic Growth

The other causes of economic growth are key components in an economy. Improving or increasing their quantity can lead to growth in the economy. These other factors include:

Natural Resources: The discovery of more natural resources like oil, or mineral deposits may boost economic growth as this shifts or increases the country’s Production Possibility Curve. Other resources include land, water, forests and natural gas.

Realistically, it is difficult, if not impossible, to increase the number of natural resources in a country. Countries must take care to balance the supply and demand of scarce natural resources to avoid depleting them. Improved land management may improve the quality of land and contribute to economic growth.

For example, Saudi Arabia’s economy has historically been dependent on its oil deposits.

Human Capital: An increase in investment in human capital can improve the quality of the labor force. This would result in an improvement of skills, abilities, and training. A skilled labor force has a significant effect on growth since skilled workers are more productive.

Physical Capital or Infrastructure: Increased investment in physical capital such as factories, machinery, and roads will lower the cost of economic activity. Better factories and machinery are more productive than physical labor. This higher productivity can increase output. 

For example, having a robust highway system can reduce inefficiencies in moving raw materials or goods across the country which can increase its GDP.

Capital Formation And Faster Economic Growth

Generally, the higher the capital formation of an economy, the faster an economy can grow its aggregate income. The word ‘capital formation’ is used in narrow sense as well as in a broader sense.

However, in a narrow sense, it refers to physical capital stock which includes machines, machinery etc. In a broader sense, it includes non-physical capital or human resources consisting of public health, efficiency, craft, visible and invisible capital. Here, we must make a clear cut distinction between ‘maintaining capital intact’ and ‘capital formation’. 

The process is known as maintaining capital intact when resources are used to replace the worn out assets including wear and tear of machinery as it does not add to productive capacity of the economy.

On the contrary, capital formation is increasing the stock of real capital which obviously helps in raising the level of production of goods and services. Therefore, the essence of the process of capital formation is the diversion of a part of society’s currently available resources to the possible expansion of consumable output in future.

In this way, the concept can be extended to cover human capital formation. In fact, it is only real physical assets and not financial assets such as shares, bonds, currency notes and bank deposits are included in capital formation as they increase the productive capacity of the economy.

What Is The Significance Of Capital Formation In Economic Development?

Capital formation or accumulation is regarded as the key factor in economic development of an economy. The vicious circle of poverty, according to Prof. Nurkse, can easily be broken in under developed countries through capital formation. It is capital formation that accelerates the pace of development with fuller utilisation of available resources.

As a matter of fact, it leads to an increase in the size of national employment, income and output thereby the acute problems of inflation and balance of payment.

In under developed countries, there is an increase in the capacity of risk taking by capital formation by which fresh natural resources are made available. It is made possible through proper and thoughtful exploitation.

Moreover, in under developed countries, capital formation creates overhead capital and necessary environment for economic development. This helps to instigate technical progress which make impossible the use of more capital in the field of production and with increase of capital in production, the abstract form of capital changes.

Modern agricultural and industrial development needs adequate funds for adoption of latest mechanised techniques, input, and setting of different heavy or light industries. Without sufficient capital at their disposal, leads to lower rate of development thus, capital formation. In fact, the development of these both sectors is not possible without capital accumulation.

The higher rate of capital formation in a country means the higher rate of economic growth. Generally, the rate of capital formation or accumulation is very low in advanced countries. In the case of under developed countries, the rate of capital formation varies between one percent to five percent while in the latter’s case, it even exceeds to 20 percent.

Capital formation improves the conditions and methods for the production of a country. Hence, there is much increase in national income and per capital income. This leads to increase in quantity of production which leads to again rise in national income. The rate of growth and quantity of national income necessarily depends on the rate of capital formation. 

So, increase in national income is possible only by the proper adoption of different means of production and productive use of same. As there is increase in the rate of capital formation, productivity increases quickly and available capital is utilized in more profitable and extensive way. In this way, complicated techniques and methods are utilized for the economy. This results in the expansion of economy activities.

Capital formation also increases investment which effects economic development in two ways. Thus, it increases the per capita income and enhances the purchasing power which, in turn, creates more effective demand. Also, investment leads to an increase in production. 

In this way, by capital formation, economic activities can be expanded in under developed countries, which in fact, helps to get rid of poverty and attain economic development in the economy. In short, both saving and investment are crucial for capital accumulation.

An economy grows in only a few specific ways. People might find new or better resources, as with the discovery of oil wells in the 1850s. More people (or more productive people) might enter the workforce. Technology might be improved, as with the invention of the Internet. 

The most important, consistent and controllable way to grow an economy is through improved capital goods structure and growing capital stock, which is where capital formation comes in.

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