MARGINAL EFFICIENCY OF CAPITAL

Hello to all of u! i m supposed to write on marginal efficiency of capital, a concept first proposed by J.M. Keynes in his book (the general theory of output, employment and productivity). the concept is very simple to understand if u c it 4m finance perspective. MEC is nothing but the internal rate of return (IRR) of a project, only whn ur able to earn more than this irr or MEC (from now onwards) a person will b willing to invest in a project. thus MEC can be taken as a hurdle rate, which determines ur investment decision.

Below i hav given a overview of this concept, it follows directly from the book by charles woelfel, an authority in this area. It would be better if u people can read up on this and then revert back with ur doubts and queries.

That rate of discount which equates present value of net expected revenue from an investment of capital to its cost; a Keynesian concept. The concept plays a major role in the Keynesian theory of investment; the level of investment is determined by the marginal efficiency of capital relative to the rate of interest. If the marginal efficiency rate is higher than the rate of interest, investment will be stimulated; if not, investment will be discouraged. A fall in the rate of interest will stimulate investment, assuming the decline is below the given marginal efficiency rate. Marginal efficiency returns should then rise (based on higher anticipations of returns from investment), and such rise above a given prevailing rate of interest will stimulate investment.

The concept is based on the ordinary mathematical technique of computing present value of a given series of returns discounted at a specified discount rate. If an investment in equipment cost $4,450 and is expected to yield returns of $1,000 per year for five years, such returns,



$1,000 $1,000 $1,000 $1,000 $1,000
............ .............. .............. ............ .............
1 + r (1 + r)^2 (1 + r)^3 (1 + r)^4 (1 + r)^5

will equate with the cost of $4,450 for the investment if the rate of discount (marginal efficiency of capital) is 4%. If the prevailing interest cost of money to finance such investment is actually below 4%, the investment will be stimulated; if it is above 4%, the investment will be discouraged.

In income-expenditure analysis, the marginal efficiency of capital is a price factor in determining whether businesses are going to borrow and invest. The rate of interest is a passive factor because businesses do not borrow merely because the interest rate is low. A stable and material gap between the marginal efficiency of capital and the rate of return will result in an increase in the level of economic activity.

The marginal efficiency of capital is determined to some extent by the expectation of profits compared to the replacement cost of capital assets. The marginal efficiency of capital can ordinarily be improved by an increase in productivity, sales, or prices, or by a decrease in the costs of production. Generally, it is the relationship between the marginal efficiency of capital and the rate of interest that causes expansion, equilibrium, or contraction in the economy.

The term net expected revenue anticipations refers to net return over depreciation. Productivity theories of investment and their justification of interest date back at least to the work of the famous Austrian Bohm-Bawerk and the early work of Dr. Irving Fisher of Yale, but in the Keynesian schema the marginal efficiency of capital was adapted as one of the three major aspects of the Keynesian model, the other two being the liquidity preference concept of determination of interest rates and the consumption function.

By Raghunandan Behra

MONETARY POLICY GLOSSARY - IMPORTANT TOOLS

OMO: Open market operations are the means of implementing monetary policy by which a central bank controls its national money supply by buying and selling government securities, or other financial instruments. Monetary targets, such as interest rates or exchange rates, are used to guide this implementation. Newly created money is used by the central bank to buy in the open market a financial asset, such as government bonds, foreign currency, or gold. If the central bank sells these assets in the open market, the money supply decreases.

High Powered money: It is the money produced by the central bank and the Government and held by the public and banks. H ‘reserve money’. H is the sum of i) currency held by the public(C), ii) cash reserves of banks(R) & iii) other deposits of the Central bank(OD). High-powered money is a macroeconomic term referring to the monetary base — that is, to highly liquid money and includes currency and vault cash.

CRR: The reserve requirement (or required reserve ratio or cash reserve ratio) is a bank regulation that sets the minimum reserves each bank must hold to customer deposits and notes. It would normally be in the form of fiat currency stored in a bank vault (vault cash), or with a central bank. These deposits are designed to satisfy cash withdrawal demands of customers. CRR is also called the Liquidity Ratio as it seeks to control money supply in the economy. An increase in CRR decreases the money with the banks and henece drains out excess liquidity from the system. Currently CRR is 5.00%.

SLR: Statutory Liquidity Ratio or SLR refers to the amount that all banks required to maintain in cash or in the form of Gold or approved securities. Here by approved securities we mean, bond and shares of different companies. This Statutory Liquidity Ratio is determined as percentage of total demand and percentage of time liabilities. Time Liabilities refer to the liabilities, which the commercial banks are liable to pay to the customers on their anytime demand. The liabilities that the banks are liable to pay within one month's time, due to completion of maturity period, are also considered as time liabilities. Statutory Liquidity Ratio (SLR) is a term used in the regulation of banking in India. It is the amount which a bank has to maintain in the form:

1. Cash

2. Gold valued at a price not exceeding the current market price

3. Unencumbered approved securities (Government securities or Gilts come under this) valued at a price as specified by the RBI from time to time.

Currently SLR is 25.00%.

Bank Rate: It is also referred to as the discount rate, is the rate of interest which a central bank charges on the loans and advances that it extends to commercial banks and other financial intermediaries. Changes in the bank rate are often used by central banks to control the money supply. Currently bank rate is 6.00%.

REPO Rate: Repo rate is the rate at which our banks borrow rupees from RBI. To temporarily expand the money supply, the central bank decreases repo rates (so that banks can swap their holdings of government securities for cash); to contract the money supply it increases the repo rates. Alternatively, the central bank decides on a desired level of money supply and lets the market determine the appropriate repo rate. Currently Repo rate is 4.75%.

Reverse Repo Rate: Reverse Repo rate is the rate at which Reserve Bank of India (RBI) borrows money from banks. An increase in Reverse repo rate can cause the banks to transfer more funds to RBI due to these attractive interest rates. It can cause the money to be drawn out of the banking system. Currently Reverse Repo rate is 3.25%.

The post is contributed By Aditya Manishi

TRANSMISSION MECHANISM OF MONETARY POLICY

Continued from previous post "MONETARY POLICY"

The transmission mechanism of monetary policy changes looks like a stepwise process. Due to change in real money supply people find their portfolios in disequilibrium due to which adjustments take place and finally the asset prices and interest rates change. If interest rates become unattractive then demand for money increases i.e. people hold larger part of their wealth as money. Lower interest rates encourage investment and spending, leading to an increase in aggregate output.

Therefore, the decision to lower CRR and SLR is an attempt by the RBI to make more funds available for lending. While when it reduces other rates s.a. reverse repo, bank rate etc. then it is trying to reduce the cost at which the credit is made available to the borrowers. Thus, all these instruments affect credit creation in the system. Inflationary pressures arise when there is too much liquidity chasing too little goods. In such a case the monetary authority has to reconsider its policy stance and decide whether it needs to tighten the policy or not.

During 1980 to 1985 US monetary authority excersised tight control over money supply which resulted in high rates of interest as compared with the rest of the world. This led to capital inflows into the economy due to high retuns provided by US financial assets. As a result dollar saw a constant appreciation during this time period. Currency appreciation became a concern for Fed as US began losing its competitive advantage in the international markets and the domestic market was flooded with cheap imported goods. This led to job-losses and hence the government was forced to reconsider its policy stance. In such a scenario the central bank can intervene, conduct monetary policy operations such that the supply of domestic currency increases to normal levels and hence the exchange rates would eventually come down.

There have been such situations where inspite of a favouravle monetary policy, the central bank could not influence the eonomic situation and the credit offtake remained poor. India too witnessed such a situation.

Also, there is a situation known as liquidity trap when monetary policy becomes ineffective. What do you understand by liquidity trap? Do you think the fiscal policy could be a relief in such a case as that of India’s (i.e. very little credit offtake), if it is used to supplement the effects of monetary policy?

I would also like you all to think about the role of monetary policy in the financial markets stability and exchange rate management !!! Hopefully some of you would ponder over it and write back….It can answer the needs of checking inflation, growth as well as stability of the capital markets by this process.

More to come on this topic.....

MONETARY POLICY

The recent crisis had a deep impact on the Indian economy as well s.t. the economic growth rate came down to 6.4% from 9%. Business confidence had hit rock bottom. Though very less, but still it seemed that there was credit demand in the economy. The banks and financial institutions were reluctant to lend (looking at the scenario in US). RBI decided that it will have to step in and increase the availability of credit in the market, infuse liquidity and lower the interest rates so that credit can be made easily available. Thus, in multiple phases RBI reduced key interest rates s.a. CRR was brought down to 5% from 9%, SLR was reduced to 24% (down by 1%), repo and reverse repo rates were reduced etc. It infused liquidity near Rs. 2 lakh crores (approx. 3% of the GDP) in the market. It also conducted open market operations for sale of bonds. All this was also necessary to bring down the call rates that had reached 20% and hence were making it difficult for the real sector to grow.

All of these measures were aimed at creating a market environment conducive for the smooth availability of credit to the productive sectors of the economy at viable rates. This was essential as the credit markets had dried up post the US subprime crisis. Mentioned above are various means through which a country’s central bank conducts its monetary policy. Monetary policy deals with the management of money supply in the economy which in turn has its bearing on the economic activity. Not only ecoomic activity, it has influence on the exchange rates, inflation rate, capital flows by means of affecting interest rates which ultimately affect economic growth. The central thrust of India’s monetary policy has been sustained economic growth with price stability.

The nominal supplies of money and bank credit growth are highly fragile to policy manipulations by the central banks. Any change in these variables can have a significant impact on the availability, allocation and offtake of credit in an economy, thus affecting its growth rate. This will in turn affect employment, real output, price level and distribution of income and wealth in the society.

Say in an economy the consumers are reluctant to spend leading to fall in demand, also the lending institutions are not willing to lend due to loss of business confidence (which may lead to an increase in call market rates of interest since the demand for credit still exists). In such a situation the economic activity comes to a standstill as the projects stand waiting in the absence of capital, output has to be lowered and hence unemployment rate increases. It is at this time that the monetary authority needs to intervene and introduce changes in policy through the various tools mentioned above. The central bank can increase the money supply by cutting down some of the key rates i.e. Repo rate, reverse repo rate, Cash Reserve Ratio, Statutory liquidity ratio etc. When the money supply in the economy increases, there is a danger of inflation going up while at the same time it helps increase the level of output and reduces interest rates. When open market operations are conducted by the central bank in which it buys bonds in exchange for money, thus increasing the stock of money (as it may pay for this purchase of bonds by printing money). Due to purchase of bonds their price in the market increases and hence the yield reduces (return/price). It is only in this situation people are prepared to hold a smaller fraction of their wealth as bonds and a larger fraction as money. So in case of expansionary monetary policy the output level increases as due to a reduction in interest rates the investment spending increases. A point to be noted here is that if money demand is highly sensitive to rate of interest then in such cases a given change in money supply requires a small change in interest rates for the change to be absorbed. Thus, the effect of open market operations conducted above would be very small on investment.

Continued in the post titled "Transmission Mechanism of Monetary Policy"......

The G as in Keynes - then and now

Govt expenditure that we hear of in the Keynesian framework included expenditure on public works, infrastructure and industrial production so as to stimulate or trigger the multiplier..at the same time facilitate the ground for private domestic investment (I). What motivates private investment? Definitely the profit motive, but also the joy of creating and controlling production and the 'animal spirits'...which symbolises the thrill of risk taking -- Keynes said 'knowing better than the market what the future will bring forth.'

Interest rates are not the only stimulus to investment...this is similar to the fact that price of a commodity is not the only reason why people buy (or not buy) it. Interest elasticity (responsiveness) is another issue we looked at today w r t the 'liquidity trap'. If investment is interest in-sensitive, then changing interest for borrowing or lending purposes will not work as stimulus. What stimulates I in the liquidity trap mode? The reason one reached such low levels of interest rate is in an attempt to stimulate investment. But investment did not respond..What will it take invt to restart? Let us bring in Keynes' G here. He says..one way to stimulate pvt I is to help incentivise I with duty cuts, waivers, exemptions that help the private enterprise reduce its cost of production. This will help it reduce the final price it offers to the customer that may in turn help increase demand for product..(Whew!!! heavy)

The other way is to make G the source of expenditure (public projects). What is the ill-effect of this route? We call it 'Crowding out'. What is this effect? When the govt decides to incur expenditure, it comes in direct conflict with the private enterprise trying to borrow..and this may in turn reduce the excess liquidity and raise interest rates. Now the coming in of govt expenditure is fine..the question we need to ask is what is the purpose of this expenditure? Was it on conspicuous govt excesses or was it on works that had abilities to create jobs and lead to demand generation. If the answer is yes..it may actually help private enterprise revive in the next cycle. The second effect is that with the rise in interest rates, idle household saving may move into productive investments and the fund crunch may be a very short term phenomenon.

One question - is it better to raise disposable incomes of people or reduce corporate taxes to stimulate an economy in recession? The answer to this question is important because it leads to different effects on the Demand generation process. Excess money in people's hands may put undue pressure on prices of the (limited) goods. While surplus spending potential in the firm may help increase production and thereby jobs and the virtuous cycle. If the economy's problem is inventory pile up and no demand --- give money to people. Will they spend if taxes fell for them or would they also postpone consumption? In order to stimulate consumption, there should be disincentive to saving or a favourable business environment. So the govt needs to make sure that the private I is stimulated simultaneously so that people's confidence grows and they spend.

One last question (this one I will not answer) - Why is a bail-out package different from a fiscal stimulus? If I made sense to you thus far..you will have this answer...Keep thinking and reading!!

FISCAL POLICY

Fiscal policy is an important macroeconomic tool that is used by the government to influence the economic acitivity. This policy operates through changes in government expenditures and revenues. This policy has its initial impact on the goods market. If we revisit the national income account identity we have a component there called as government spending (G). Government conducts fiscal policy by changing government spending and tax rates (source of revenue for government).

When the consumer confidence is low i.e. people are not willing to spend, the demand for goods and services declines. In such a situation firms see a lot of inventory pile up. They are forced to cut down production, reduce employment and may be at times go for partial shut downs. Due to high attritions and wage cuts purchasing power in the hands of the consumers decreases. This adds to the problem leading to shrinking of the size of the economy and hence the GDP growth rate also comes down. The wheel of economic activity freezes as there is no fresh demand creation and no further expansion.

In such a scenario the role of fiscal policy becomes important. The government in such cases can step up its spending on public works or infrastructure projects (core sector which has the potential of generating employment in the economy). The basic idea is to stimulate demand by providing purchasing power to the consumer. Another way of conducting the fiscal policy is by changing tax rates. The latest budget saw the government deciding to raise the minimum taxable income limit. This will lead to an increase in the disposable income (income less taxes) in the hands of the consumers which is expected to be spent on consumption of goods and services.

The fiscal stimulus works through its primary and secondary effects. Say for instance, government initiates a construction project (say the airport construction, long term in nature i.e. at least a year long) in the city of Hyderabad. The immediate effect of such a move will be employment generation i.e. in the form of recruitment of workers, engineers etc. Also, demand for raw-material like steel, cement etc. will be generated, thus benefiting the allied sectors as well. When wages will be paid out to the workers, they will get purchasing power in their hands which will be spent on consumption of goods and services (s.a. clothes, fmcg, food, automobiles, etc.). The amount of income that will be spent is cY i.e. marginal propensity to consume times the income (marginal propensity to consume, MPC, can be defined as increase in consumption per unit increase in income, say for instance out of every Re 1 increase in income an individual spends Rs. 0.80, then his/her MPC is 0.8). Hence, consumption demand will be stimulated which in turn will stimulate the economic activity in other sectors as well (i.e. consumer durables and non-durables). These are the secondary effects of government expenditure increase (expansionary fiscal policy). Thus, the wheel of econimc activity is again set in motion. The phenomenon of multiplier works here i.e. the result of Rs. 1 million increase in G is more than that i.e. 1/1-c times where c is the marginal propensity to consume. So, if we assume c as 0.8 then multiplier is 5 and the impact of G will be 5 x Rs. 1 million.

Another dormant tool of fiscal policy is transfer payments given by the government in the shape of social security allowances and grants etc, Government can also use taxation and transfers to very well encourage or discourage few sectors and industries, control imports and exports activity etc.

One drawback of fiscal policy is crowding out of private investment i.e. a decline in private investment due to rise in interest rates resulting from increase in government expenditure. An increase in G leads to increases in income and rate of interest. Since rate of interest is the cost of investment, there is a decline in investment. The problem is aggravated if government borrows excessively to finance its fiscal expansion. This process can be understood better with the help of IS-LM framework.

Are the Germans really small spenders?

After the discussion on the Germany case today, I would like to address a couple of questions on the consumption behavior of the Germans who belong to an industrialized, well-developed and progressive state. The MPCs of people in such countries tends to be relatively low - reasons being they have already achieved a high level of consumption and their incremental consumption needs are not high value. They tend to be more savings (investment) oriented after their consumption needs are well satisfied. Comparing Germany's low spending behavior to the high spending Chinese or Indians may not be fair comparison whatsoever.

The second issue to ponder over would be if taxing the people's income and reducing their spending power is being compensated in the form of subsidized spending on education and healthcare. Does it make sense for the State to get money out of the hands of spenders to compensate the unproductive non-spenders? Consumption follows in a business cycle. It is production and improved productivity that will lead the movement out of stagnant growth periods.

Germany seems to be in a state of what is 'steady-state growth' where growth in specific leading sectors has already reached a high point and marginal growth is sort of inconsequential. Do they need a shift in focus? If so for a country with 70% of GDP coming out of services, a nation that is highly industrialised (30% from industry), what do you think is the way forward? What should be Germany's focus for the next decade based on what you have read in the case? Do you think it is the end of the road and that they would need another war to bring that "Aufklarung"?

Will look forward to your views......