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    Marginal Efficiency of Investment

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    shashank
    The document discusses Marginal Efficiency of Investment (MEI) and Marginal Efficiency of Capital (MEC). MEI represents how responsive investment is to interest rate changes, but Keynes argued investment is relatively unresponsive, especially in recessions or booms. Instead, he emphasized expectations and MEC. MEC is a downward sloping curve showing diminishing returns to investment. Investment is determined by comparing MEC to the interest rate opportunity cost. Lower interest rates can make previously unprofitable projects viable, increasing investment. MEC can shift with optimism or pessimism, potentially offsetting the effects of interest rate changes on investment.

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    Marginal Efficiency of Investment

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    shashank
    657 views2 pages
    The document discusses Marginal Efficiency of Investment (MEI) and Marginal Efficiency of Capital (MEC). MEI represents how responsive investment is to interest rate changes, but Keynes argued investment is relatively unresponsive, especially in recessions or booms. Instead, he emphasized expectations and MEC. MEC is a downward sloping curve showing diminishing returns to investment. Investment is determined by comparing MEC to the interest rate opportunity cost. Lower interest rates can make previously unprofitable projects viable, increasing investment. MEC can shift with optimism or pessimism, potentially offsetting the effects of interest rate changes on investment.

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    The document discusses Marginal Efficiency of Investment (MEI) and Marginal Efficiency of Capital (MEC). MEI represents how responsive investment is to interest rate changes, but Keynes argued investment is relatively unresponsive, especially in recessions or booms. Instead, he emphasized expectations and MEC. MEC is a downward sloping curve showing diminishing returns to investment. Investment is determined by comparing MEC to the interest rate opportunity cost. Lower interest rates can make previously unprofitable projects viable, increasing investment. MEC can shift with optimism or pessimism, potentially offsetting the effects of interest rate changes on investment.

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    657 views2 pages

    Marginal Efficiency of Investment

    Uploaded by

    shashank
    The document discusses Marginal Efficiency of Investment (MEI) and Marginal Efficiency of Capital (MEC). MEI represents how responsive investment is to interest rate changes, but Keynes argued investment is relatively unresponsive, especially in recessions or booms. Instead, he emphasized expectations and MEC. MEC is a downward sloping curve showing diminishing returns to investment. Investment is determined by comparing MEC to the interest rate opportunity cost. Lower interest rates can make previously unprofitable projects viable, increasing investment. MEC can shift with optimism or pessimism, potentially offsetting the effects of interest rate changes on investment.

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    Marginal Efficiency of Investment (MEI) vs.

    Marginal Efficiency of Capital


    (MEC)
    The MEI curve represents the interest elasticity of demand for investment (or capital
    goods), or in other words, how responsive investment is to a change in interest
    rates. Interest rates represent the cost of borrowing. Theoretically, the lower the
    rate of interest, the cheaper it is for firms to finance investment, and the more
    profitable the investment will be. Hence, the level of investment will rise.

    Keynes, however,
    suggested that
    investment is in fact
    relatively
    unresponsive to
    changes in interest
    rates, particularly at
    the extreme ends of
    the Trade Cycle.
    During a recession,
    businessmen are
    generally pessimistic
    about the future
    outlook and there is
    also likely to be
    excessive unused productive capacity, which prevents a fall in interest rates from
    stimulating I. On the other hand, during a boom, their optimism may cause them to
    disregard high interest rates. Hence, MEI is more likely to look like the relatively
    inelastic MEI1 than the relatively elastic MEI2. (Note: Graph has been mislabelled in
    Page 1 of Compact Revision Notes!! :( Apologies - MEI is the relatively inelastic
    curve while MEI1 is the relatively elastic curve.. Thanks to Danielle for pointing out
    error!)
    Keynes instead emphasized the importance of expectations (entrepreneurship
    mood), which is affected by the state of the market for their product (which is in
    turn determined by factors like political stability, cost of production, conducive
    business climate etc). The expected rate of returns from investment is measured by
    Marginal Efficiency of Capital (MEC).
    MEC is a downward sloping curve because, as the firm invests more, MEC will fall
    due to diminishing returns (i.e. the first few projects invested in tend to give a
    higher rate of returns, with subsequent projects yielding lower and lower returns).

    The decision to invest is determined by a comparison of MEC and the opportunity


    cost of the investment (i.e. interest rate). As long as the MEC is greater than interest
    rates, firms will invest more (i.e. the project is regarded as worthwhile). It will stop
    investing when the MEC = i/r. Hence, as seen in the above diagram, if interest rates
    fall from r1 to r2, projects with lower expected returns, seen previously as
    unprofitable, will NOW appear viable, and so, more I will occur. This increases I from
    I1 to I2.
    Increasing optimism translates into higher expected returns and the MEC can shift
    to the right. Similarly, a collapse of business confidence causes a downward revision
    of future returns and the MEC curve shifts to the left.

    Hence, it can be seen above that a rise in interest rates may not dampen I if, at the
    same time, MEC has increased.

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