Sunday, September 10, 2006

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.

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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).

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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.

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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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