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Marginal Efficiency of Investment (MEI) vs.

Marginal Efficiency of Capital

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
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
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.