Page 115 - DECO201_MACRO_ECONOMICS_ENGLISH

Macro Economics

Notes (PV is present value, Qn are prospective returns, I is current rate of interest)

Obviously, the PV is less than the obsolete sum to be received in future. In the calculation of PV,
the technique of discounting has been applied. The higher the rate of discount (interest), smaller
will be the present value (PV). If PV of the asset exceeds the supply price of that capital asset, it
may be considered worthwhile to undertake this investment. On the contrary, if the PV of asset
is lower than supply price of asset, then investment cannot be undertaken, as it will lead to loss.
According to Keynes, MEC is the rate of discount which will equalise the supply price of capital
with the prospective return of capital asset. Thus,

Where S is supply price of capital Q is annual returns, r = rate of discount which will bring the
P n
two sides into equality.
Thus r will be the MEC. It is not necessary that the returns are the same in every year. When yield
is constant, then MEC = Y/P
Where, Y is annual yield and P is supply price of capital.

The MEC, in general, is the highest rate of return over the cost expected from an additional or
marginal unit of that type of asset. Investment would be undertaken, other things remaining
same, if the MEC is greater than rate of interest. As we know, MEC declines or shows diminishing
returns with an increase in investment (Figure 6.3).
Figure 6.3

The major causes of decline in MEC are:
Reduction in prospective yield
Increase in supply price of capital.

The two most important determinants of investment are MEC and rate of interest. As long as
MEC exceeds rate of interest, investment will be forthcoming till such a time when these two
variables are equal. This will determine the equilibrium volume of investment (I in Figure 6.4).
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