Answer to Question #194241 in Macroeconomics for Selma Shilongo

Question

Use an appropriate diagram based explain why the MEC-curve might overstate the

additional investment that could be generated in an economy with a one-percent

reduction in the rate of interest.

(5)

Answer 1

The maximum expected return on an additional unit of a capital asset over its expense is known as MEC. It is a new capital asset's estimated rate of profitability. J.M. is a fictional character created by J.M. MEC was described by Keynes as the rate of discount that would make the present value of a series of annuities based on the expected returns from capital assets over the life of the asset just equal to the supply price. The MEC plan is another name for the investment-demand schedule.      

The MEC schedule depicts a realistic relationship between MEC and the sum of investment in a specific form of capital asset for the entire economy at a given point in time.

Investment                   Rate of Interest (In %)

(In Million

US $)

MEC /

200                               10

250                               9

400                               7

750                               5

1000                            3

The marginal utility of capital is defined by the MEC curve in the diagram above. It slopes downward from left to right, implying that as investment rises, so does marginal efficiency.

The rate of interest that applies at any given time determines whether or not to invest. If the rate of interest is 10%, the investment is $200 million because MEC is equivalent to the rate of interest at this stage. The MEC is the investor's return, while the interest rate is his expense. Obviously, the return on capital must be at least equal to the cost of capital, which is the rate of interest. If the interest rate falls to 9%, it would be worthwhile to spend $250 million in the United States. As a result, the MEC and the rate of interest switch in lockstep.

Position and Shape of MEC Curve: The elasticity of MEC determines how much the amount of investment changes in response to changes in the interest rate. If MEC is relatively interest-elastic, a small reduction in the interest rate can result in a significant increase in the amount of investment. If the MEC, on the other hand, is relatively interest-inelastic, a significant drop in the rate of interest does not result in a significant increase in the amount of investment.