Question

Explain how a permanent decrease in productivity would effect the capital market. Explain how the mentioned shock alters user cost, MPK,K,I,S,r. Explain answers graphically.

Answer 1

1. Investment Function: Investment function is the behaviour of investment corresponding to different levels of income. Investment means expenditure made on purchase of new capital assets like machines, tools, equipments etc. It means an addition to existing stock of assets to increase productive capacity of an economy.

According to Keynes, volume of investment depends upon (i) marginal efficiency of capital (MEC is the rate of return from marginal unit of capital) or rate of return and (ii) rate of interest. Firms undertake investment as long as return form investment is greater than cost. There are following two types of investment:

1. Induced Investment: This investment is made with the motive of earning profit as done by private sector. It is a positive function of national income i.e. it changes directly with change in national income. It is income elastic. However, it is an inverse function of rate of interest. It changes inversely with the change in rate of interest. Induced investment curve is like supply curve. It has a positive slope.
2. Autonomous Investment: It is investment which is to be done irrespective of level of income and rate of interest. It is income inelastic. It is a straight line parallel to income axis. In our study we have assumed investment to be autonomous investment. It is generally done by the government.

If there is a permanent decrease in productivity, it will decrease Marginal efficiency of the investment. With decrease in efficiency of investment, investment decreases. With decrease in investment, AD decreases. With decrease in AD, level fo output and employment both decrease.

It can be shown with the help of following diagram.

Original Economy was in equilibrium at point A where MEC = Rate of interest. With decrease in productivity, MEC decreased to MEC₀. With this shift new equilibrium gets established at point E₁. at a lower level of investment in panel A.

With decrease in investment, AD shifts from AD to AD₀. With decrease in AD New equilibrium gets established at point E₁ at a lower level of output and lower level of employment from point E to E1.

ROI RoI6 MET MET MECO Q fand B AD/Output kuso Natal income. QE