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There are three kinds of Capital Formation: Gross Fixed Capital Formation (acquiring buildings and machinery to produce more goods), Changes in Stocks (storing up goods for sale at a later date), and acquisition of Valuables (such as gems, antiques and works of art).

Capital Formation is included in Gross Domestic Product when we use the Expenditure Approach, and so increased capital formation is associated with economic growth.

Gross Fixed Capital Formation

If a manufacturer wants to start making goods, they will probably need a building for their factory, machines to produce the goods, and some raw materials to turn into the final product. The raw materials are Intermediate Consumption. They are used up in making the product. The building and the machines are Fixed Assets that should last for years and be used many times. The acquisition of the buildings and the machines is called Gross Fixed Capital Formation (GFCF). If assets are disposed of, for instance, if a factory is sold, that is negative GFCF. So Fixed Assets are balance sheet items, while Fixed Capital Formation shows the transactions as assets are acquired and disposed of. We talk about 'Gross' Fixed Capital Formation because it does not take account of the wear and tear and decline in the value of the assets that stay on the balance sheet (Consumption of Fixed Capital). 

The main types of Fixed Capital Assets are:

  • Dwellings and other construction (factories, roads and so on)
  • Machinery and equipment (including vehicles)
  • Cultivated biological resources (for example orchards, livestock for breeding)
  • Intangible fixed assets (for example, research and development, patents, computer software, original works of art, and oil and gas exploration)
  • Costs of transfer of ownership of Non-Produced Non-Financial Assets such as land (for example, stamp duties and solicitors' fees)

The term 'capital assets' which is sometimes used in business accounting includes Fixed Assets, but it has a wider meaning, and includes other assets, such as Natural Resources.

Sometimes Fixed Assets are referred to as ‘real assets’, to distinguish them from Financial Assets (such as deposits or shares). However, as the above list shows, the Fixed Assets include intangible items like patents (see Intellectual Property).

On the other hand, not all real physical assets are included in GFCF. Only purchase of assets which result from human effort is considered to be GFCF. Acquisitions of Non-Produced Assets like land, oil deposits or mobile phone spectra are not part of capital formation.  Material that get used up in production is, as mentioned, Intermediate Consumption.

Durable goods which are used to satisfy final needs and wants and which are not used in production are Final Consumption Expenditure of households or government. For example, fridges, televisions and even cars purchased by households are classified as Final Consumption Expenditure. The exception to this is dwellings: buying houses and apartments is considered as GFCF because the home is then used in the production of dwelling services for the owners (see Imputed Rent). 

Between 2018 and 2020, a good deal of GFCF in Ireland was in Intellectual Property (IP). Most of this IP has been imported, as manufacturers and IT service providers have bought the know-how to make their products from other companies abroad. As we saw in GDP Measurement, while capital formation adds to GDP, imports subtract from GDP. Hence, if there are large imports of fixed capital like IP, fixed capital formation goes up, and imports go up by the same amount. Imports and capital formation thus cancel each other out, so there is no direct impact on GDP.

Changes in Stocks and Inventories

The second kind of capital formation is changes in assets which are not fixed, but which are expected to be sold on. These are changes in stocks, in other words, the change in the value of goods in the company’s warehouse.

For example, a company may manufacture a large volume of material in 2020 but not sell it until 2021. The unsold goods will be counted in Output in 2020, they then go into stock and are also treated as capital formation by the company in 2020. If they are sold in 2021, they are deducted from capital formation then; their sale does not reduce the Output of the company because the Output of a manufacturer is its production, not its sales. As well as manufacturers, wholesale traders and retail traders often have significant amounts of stock.

Of course, the company may have had some stock already in its warehouse at the start of the year, and that has already been counted as capital formation of the previous year. So we do not count the total stock as capital formation, but the change in stock. What is more, the value of the stock may increase because of price changes, even if the quantity is the same, and this price change is excluded from calculations as the Adjustment for Stock Appreciation.

Acquisition of Valuables

Acquisition of valuables is generally a small part of the total Capital Formation. Valuables are goods that are not used to produce other goods or services: that is they are not part of Gross Fixed Capital Formation. Furthermore, valuables do not generally deteriorate over time: that is they are not part of Final Consumption Expenditure. Valuables are goods that are bought as a way of storing value. They include precious stones such as diamonds, precious metals such as gold, and antiques and art objects such as paintings. Value is also stored in Financial Assets as well as in Valuables.

Capital Formation at Constant Prices

Read next: Consumption of Fixed Capital

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