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TERM 1- Credits 3 (Core)

Prof Madhu & Prof Rajasulochana


TAPMI, Manipal
Session 9

Recap.

Investment Function

I = f (Marginal Efficiency of Capital,


Market rate of interest )

The MEC shows the negative relationship between


the internal rate of return and the stock of capital.
Graphically, MEC schedule is
downward sloping.
Reasons:
1. As capital stock increases,
diminishing returns will set in.
2. As demand for capital stock
increases, purchase price of capital
goods go up.

Internal rate of return (%)


MEC

Stock of capital

Market rate of interest (i)


It is determined in the loanable fund market.
Demand for consumption loans and investment
loans = Supply of loanable funds.

Why do we have multiple interest rates?


Expected Inflation rates
Risks and Uncertainties
Transaction Cost
Duration of Loans
Terms and costs of administration

Investment Decision by Firm


If the MEC (e) is greater than the market rate of
interest (i), it implies that the present value (PV) of
the capital good is greater than its purchase price
(P) and the firm should invest; vice versa.

Diagrammatically, Investment level can change


under 2 scenarios
Change in the cost of borrowing
Market rate of interest

Change in the expected rate of return


Market rate of interest
MEC2

MEC

MEC3

MEC1

Investment

Investment

Autonomous Investment at different levels of i


E=Y
Exp (E)

I at i =3%
I at i = 5%

Output(Y)

Induced Investment depends on Y


E=Y
Exp (E)

I = c + dY

c
Output(Y)

RecapNational Income Determination


Models

Case 1:Equilibrium output determination


(C + Autonomous Investment)

The multiplier effect with autonomous investment is


(1/1-b).

Diagrammatically,
E=Y
Exp (E)

C+I
C

Y1

Y2

Mutliplier effect

Output(Y)

Case 2: Equilibrium output determination


(C + Induced Investment)

The multiplier effect with induced investment will be higher


than the multiplier effect with autonomous investment.

Diagrammatically,
E=Y
Exp (E)

C+I
C

c
a
Y1

Y2

Mutliplier effect

Output(Y)

Role of Government
Its function is to collect taxes, make transfer
payments and spend on socio-economic
projects.

Taxes and transfer payments affect


consumption function

Keynesian Model in short


E=Y
Exp (E)

C+I+G
C+I

Y1

Y*

unemployment

Output(Y)

Case 3:Equilibrium output determination


(C + Autonomous I + Autonomous G with transfers and
lump sum tax)
An increase in mpc would raise the
multiplier effect on output, but an
increase in tax rate would have an
adverse impact on output.

If increased G is financed solely by increased T,


how would it impact the equilibrium output ?

Balanced Budget Multiplier

Case 4:Equilibrium output determination


(C + Autonomous I + Autonomous G with proportional
income tax)
The presence of income tax
lowers the
multiplier..hence is
regarded as an automatic
stabilizer.

Limitations of Keynesian Model


Cannot explain the stagflation, that is the simultaneous
existence of unemployment and inflation.
Advocates growth of the state and inefficient and
corrupt spending.
People have rational expectations about future and see
a tax cut as only temporary, and therefore dont spend.
Instead they save the tax cut in anticipation of future
tax rises.

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