While carrying process of production, machinery and other capital equipment’s are used and undergo wear and tear. Thus, their useful life gets reduced. This wear and tear of capital goods is termed as depreciation or consumption of fixed capital. Depreciation is not the only cause of reduction in useful life of capital goods. They may also be caused due to economic, technical or external changes. e.g. with the introduction of computer, typewriters nave become obsolete. This is known as obsolescence of capital equipment. But, when such obsolescence is already estimated in advance and is taken care while calculating depreciation, it is treated as consumption of fixed capital. Capital may also be useful because or unknown or external cause like fire, flood, storms etc. such losses are termed as capital losses.
To keep the production activity smooth, old and obsolete physical assets need to be replaced. Provision made for replacing the old assets is known as depreciation provision or replacement cost of fixed assets. By making depreciation provision, the value of existing capital Cs kept Gross capital formation can be financed by: Gross Domestic Saving and net borrowing or capital inflow from abroad. Gross domestic saving comprises of provision of depreciation of funds and net domestic saving. Net capital inflow from abroad constitute of net capital transfer from abroad and net borrowing. An economy tries to finance capital formation of country by saving generated in domestic economy. However, in developing economy especially India, domestic saving are not enough to finance the development plan requirements of economy. Therefore,
Total capital formation = domestic saving + net inflow of capital from abroad
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