Investment Keynes Mec and Mei
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Naresh SehdevInvestment Keynes Mec and Mei
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The Keynesian Theory of Investment
(With Diagram and Example)
Let us make an in-depth study of the Keynesian Theory of
Investment.
According to the classical theory there are three determinants of
business investment, viz., (i) cost, (ii) return and (iii) expectations.
According to Keynes investment decisions are taken by comparing the
marginal efficiency of capital (MEC) or the yield with the real rate of
interest (r).
So long as the MEC is greater than r, new investment in plant,
equipment and machinery will take place.
However, as more and more capital is used in the production process,
the MEC will fall due to diminishing marginal product of capital. As
soon as MEC is equated to r, no new investment will be made in any
income-earning asset.
Marginal Efficiency of Capital:
The MEC is the rate of discount which equates the present value of a
series of cash flows obtainable from an income-earning asset like a
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machine over its entire economic life to the cost of the machine. The
MEC is the rate of return at which a project is expected to breakeven.
This depends on the immediate profits (cash flows) expected from
operating the project and the rate at which these are expected to
decline through reduction in the price of output, or increases in the
real wages or cost of raw materials and fuel.
If all possible projects in an economy are arranged in descending order
of their MEC, investors will accept those with MEC higher than r and
reject those whose MEC is lower than r. The MEC is not the same as
the marginal product of capital which is concerned only with the
immediate effect of additional capital on possible output and not with
how long the resulting profits can be expected to persist.
The MEC is the rate of return (profits) on an extra rupee worth of
investment. The marginal efficiency of capital decreases as the amount
of investment increases (as shown in Fig. 18.1). This is because initial
investments are concentrated on the best opportunities and yield
high rates of return; later investments are less productive and secure
progressively lower returns.
The amount of investment undertaken depends not only on expected
returns but also on the cost of capital, that is, the interest rate.
Investment will be profitable up to the point where the marginal
efficiency of capital is equal to the cost of capital. In Fig. 18.1 at an
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interest rate of 20% only 0I0 amount of investment is worthwhile. A
fall in the interest rate to 10% increases the amount of profitable
investment 0I1.
If the supply price of capital goods changes over time it becomes necessary
to draw a distinction between MEC and marginal efficiency of investment
(MEI).
It will be readily apparent from Fig. 18.1 that there is a link between
the monetary side of the economy and the real economy a fall in
interest rates will stimulate more investment, which, in its turn, will
result in a higher level of national income.
The MEC is calculated by using the following formula:
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where C0 is the purchase price of the machine in the base year, R1, R2,
etc. are the expected cash flows from the machine in the first, second
and subsequent years and e is the MEC which acts as the balancing
factor. It makes the two sides of the above equation equal. Here Rn is
the expected cash flow from the machine in the last year which also
includes the scrap value of the machine.
It may be noted that e varies directly with r and inversely with C0, i.e.,
the initial cost of purchasing the machine. A simple method of
calculating e for an infinitely durable capital good is available. In this
case the economic life of the machine (which depends on the annual
rate of depreciation) is not known. We know that
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The term R is called by Keynes the expected (prospective) rate of
return on new investment (the machine) and C0 is the purchase price
of the machine. If e exceeds r, an income-earning asset like a machine
should be purchased.
Example:
2. Suppose you have an opportunity to purchase an asset which costs
Rs. 1,000. It is expected to yield Rs. 585 at the end of the first year and
Rs. 585 at the end of the second year (and zero thereafter). If the
market rate of interest is 10%, is it to your advantage to purchase the
asset? Explain your answer.
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Factors Determining Investment:
Anything which increases a firms profit prospects by increasing R will
increase its level of investment. On the other hand, if the purchase
price of capital (C0) increases, investment will fall.
The following factors affect a firms investment decisions:
(i) Increased optimism among managers:
If managers are more optimist about the future, they will place more
orders for machines. This will enable them to make more profit by
venturing out in those areas where demand for consumer goods is
picking up.
(ii) An increase in the growth rate of the economy:
Keynes assumed that all investment is autonomous and is thus
independent of national or per capita income. However, according to
the acceleration theory of investment (to be discussed later in this
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chapter), investment has an induced component as well. So anything
which increases the demand for consumer goods is always beneficial
for the capital goods producing industry.
If Indias growth rate (as measured by the annual rate of increase of
per capita income) increases there will be more demand for consumer
goods such as food and textiles. So industries producing such goods
will be stimulated and the managers of such industries will place more
orders for purchase of machines.
In other words, there will be more demand for food-producing and
textile-producing machines. This is because the demand for capital
(investment) goods is a derived (indirect) demand. In fact, the
acceleration principle suggests that a small increase in the demand for
consumer goods leads to an accelerated increase in the demand for
capital goods.
(iii) An increase in capital stock:
An increase in societys stock of capital all other factors remaining
the same will lead to a fall in the marginal physical product of
capital and will reduce the MEC by lowering the prospective rate of
return on new investment.
(iv) A change in technology:
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A favourable technological change (not an adverse technology shock)
will shift the MEC schedule to the right and will increase the volume of
investment even if the rate of interest remains constant.
(v) Changes in the rate of interest:
Economists differ in their views about the interest rate sensitivity of
investment. Some Keynesian economists argue that investment
depends largely upon expected return and is not very interest rate
sensitive, so that even large changes in interest rates have little effect
upon investment (the marginal efficiency of capital curve being very
steep).
Thus the Keynesians economists claim that monetary policy will not
be very effective in influencing the level of investment in the economy.
By contrast the monetarists argue that investment is very interest
rate-sensitive.
So even small changes in interest rates will have significant impact
upon investment (the marginal efficiency of capital/investment curve
being very shallow). Thus, monetarists claim that monetary policy will
be effective in influencing the level of investment. Empirical evidence
tends to support the Keynesian view that interest rates have only a
limited effect on investment.
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However, the neo-classical economists such as Dale Jorgenson and his
co-workers have abandoned the classical and the Keynesian theories
of investment on the ground that both are unrealistic. They have
developed an alternative theory of investment in terms of the profitmaximising behaviour of a firm under perfect competition. It is to this
theory to which we turn now.
YOU NEED TO KNOW MORE ABOUT KEYNES
MORE NOTES ADDED
1] ROLE OF EXPECTATIONS IN KEYNES THEORY
2] KEYNES THEORY DISTINCTION BETWEEN MEC AND MEI
3] ROLE OF KEYNES AS SPECULATOR
ROLE OF ANIMAL SPIRITS IN KEYNES THEORY
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