Unit 2 MEC & MEI - BBA NOTES PDF

Preview

Summary

BBA NOTES...

Description

RELATIONSHIP BETWEEN CONSUMPTION, SAVING AND INVESTMENT FUNCTION •

The Keynesian theory explains how consumption and investment can help the economy reach equilibrium.

•

Savings and investment can also help the economy reach an equilibrium.

•

An increase in savings leads to a decrease in national product whereas an increase in investment demand leads to an increase in national product.

When savings equal investments, the economy reaches its equilibrium point. Keynes believed that government intervention can reduce the level of unemployment. That the level of national income is determined by the equality of planned saving and planned investment can be derived from the equilibrium condition explained above that level of income is equal to effective demand. That is, Y = AD Now in our simple economy, effective aggregate demand (AD) is equal to the sum of consumption expenditure and investment expenditure. Thus Y=C+I Now C = Y – S Substituting Y – S for C in equation (ii) we have Y=Y–S+I Y–Y+S=I or S = I Saving function as derived from the consumption function (C = a + by) can be written as S = – a + (1 – b) Y In equilibrium I = – a + (1 – b) Y (1 – b)Y = I + a Y = 1/1-b (I + a) Where 1/1 – b is the value of multiplier b = marginal propensity to consume 1 – b = marginal propensity to save.

Determinants of the Level of Investment • The decision to invest in a new capital asset depends on whether the expected rate of return on the new investment is equal to or greater or less than the rate of interest to be paid on the funds needed to purchase this asset. • It is only when the expected rate of return is higher than the interest rate that investment will be made in acquiring new capital assets. • There are three factors that are taken into consideration while making any investment decision.  Cost of the capital asset  Expected rate of return from it during its lifetime  Market rate of interest. Keynes sums up these factors in his concept of the Marginal Efficiency of Capital (MEC).

Marginal Efficiency of Capital (MEC) MEC defined as that rate of discount which would equate the price of fixed capital asset with its discounted value of expected income. It depends upon two major factors: 1. Supply Price of Capital Asset: Keynes has termed the cost of acquisition of the assets as the supply price or replacement cost of capital assets. In case of construction activities it will spread over to number of years. 2. Prospective Yields from Capital assets: It means the expected revenue from the sale of output produced by the assets during its life time minus variable cost MEC = Prospective yield/Supply price*100 It can be also defined as the future return of the assets.

Keynes used the term “Annuity”. The present value of these future annuities can be obtained by discounting each annuity for number of years. PV=A/ (1+r)n Where, PV= Total discounted Present Value of the Future Stream of Income expected from the investment. A= Expected yield from the Capital r= Discounting rate or annual yield rate.

Example: If the supply price of a capital asset is Rs. 20,000 and its annual yield is Rs. 2,000, the marginal efficiency of this asset is 2000/20000 × 100 = 10 per cent.

Thus the marginal efficiency of capital is the percentage of profit expected from a given investment on a capital asset DECISION RULE FOR DOING THE INVESTMENT • In order to find out whether investment is worthwhile to purchase a capital asset it is essential to compare the present value of the capital asset with its cost or supply price. •

If the present value of a capital asset exceeds its cost of buying, it pays to buy it.

• On the contrary, if its present value is less than its cost, it is not worthwhile investing in this capital asset. The same results can be had by comparing the MEC with the market rate of interest.  If the MEC of a capital asset is higher than the market rate of interest at which it is borrowed, it pays to purchase the capital asset, and vice versa.

 If the market interest rate equals the MEC of the capital asset, the firm is said to possess the optimum capital stock.

The Marginal Efficiency of Investment (MEI) • The marginal efficiency of investment is the rate of return expected from a additional unit of investment on a capital asset after covering all its costs, except the rate of interest. • It is negatively sloped because as the volume of investment increases, MEI declines due to the fall in the expected rate of profit and rise in the supply price of the capital. • Like the MEC, it is the rate which equates the supply price of a capital asset to its prospective yield. The investment on an asset will be made depending upon the interest rate involved in getting funds from the market. • A low rate of interest (borrowed money) in the economy will lead to increase in investment in new project. Thus MEI relates the investment with Rate of Interest.

In this MEI curve there are two important issues that are considered: a) A low rate of Interest rate leads to an increase in Investment: There are two situation under this:

1) Elastic MEI Curve(MEI 2): In this situation the changes in rate of interest will lead to higher change in investment.

2) Less Elastic MEI Curve (MEI 1): In this situation the changes in rate of interest will lead to lesser change in investment....