Marginal Efficiency of Capital MEC
savings give a lower return making
The marginal efficiency of capital displays
the expected rate of return from investment,
at a particular given time (or the profitability
of a capital asset). The marginal efficiency
of capital is compared to the rate of interest
Keynes described the marginal efficiency of
capital as:
“The marginal efficiency of capital is equal
to that rate of discount which would make
the present value of the series of annuities
given by the returns expected from the
capital asset during its life just equal to its
supply price.” – J.M.Keynes, General
Theory, Chapter 11
This theory suggests investment will be
influenced by:
The marginal efficiency of capital
The interest rates
Generally, a lower interest rate makes
investment relatively more attractive.
If interest rates, were 3%, then firms would
need an expected rate of return of at least
3% from their investment to justify
investment.
If the marginal efficiency of capital was
lower than the interest rate, the firm would
be better off not investing, but saving the
money.
Why are interest rates important for
determining the Marginal efficiency of
capital?
To finance investment, firms will either
borrow or reduce savings. If interest rates
are lower, it’s cheaper to borrow or their
investment relatively more attractive.
Marginal Efficiency of Capital
A cut in interest rates from R1 to R2 will
increase investment to I2.
The alternative to investing is saving money
in a bank, this is the opportunity cost of
investment.
If the rate of interest is 5% then only
projects with a rate of return of greater than
5% will be profitable.
How Responsive is Investment to Interest
Rates?
In Keynesian investment theory, interest
rates are one important factor. However, in a
liquidity trap, investment may be
unresponsive to lower interest rates. In some
circumstances,
In a liquidity trap, business confidence may
be very low. Therefore, despite low interest
rates, firms don’t want to invest because
they have low expectations of future profits.
They resort to investing their money rather
than saving it.
The liquidity trap is the situation in which
prevailing interest rates are low and savings
rates are high, making monetary policy
ineffective. In a liquidity trap, consumers
choose to avoid bonds and keep their funds
in savings, because of the prevailing belief
that interest rates will soon rise.
Factors which shift the Marginal
Efficiency of Capital
1. The cost of capital. If capital is cheaper,
then investment becomes more attractive.
For example, the development of steel rails
made railways cheaper and encouraged
more investment.
2. Technological change. If there is an
improvement in technology, it can make
investment more worthwhile.
3. Expectations and business confidence.
If people are optimistic about the future,
they will be willing to invest because they
expect higher profits. In a recession, people
may become very pessimistic, so even lower
interest rates don’t encourage investment.
(e.g. during recession 2008-12, interest rates
were zero, but investment low)
4. Supply of finance. If banks are more
willing to lend money investment will be
easier.
5. Demand for goods. Higher demand will
increase profitability of capital investment.
6. Rate of Taxes. Higher taxes will
discourage investment. Sometimes,
governments offer tax breaks to encourage
investment.
Marginal Efficiency of Investment (MEI)
of all Firms| Macro Economics
Marginal Rate of Investment (MEI) #
Subject Matter:
The expected profit from an investment, as
percent of the investment, measures the rate
of return on the investment.
Economists call the expected rate of return
on an addition to capital investment as the
marginal efficiency of investment (MEI).
More precisely, it is the expected rate of
return over cost of an additional unit of a
capital good. Thus, there can be MEI or
expected rate of return of 25 percent for one
type of investment, 15 percent for another,
and so on.
As pointed out by terner, what Keynes had
called MEC was in fact the MEI.
In order to gain a better understanding of the
MEI we study its graph given in Figure.
The figure 8.6 shows that, at any given time,
a business firm is faced with a number of
investment opportunities these may include:
1. Renovating its existing plant
2. Purchasing new machines
3. Acquiring additional power facilities
4. Installing a computer system
Each project competes for a firm’s limited
funds. However, some projects are expected
to be more profitable—that is, to have a
higher rate of return (or MEI) than others. In
view of this, which projects should
management select? Or, in other words, how
much investment expenditure should
management undertake?
The first step in answering this question is to
imagine that the management of a firm rank
alternative investment projects in decreasing
order of their MEIs.

Figure, each project’s cost and the
corresponding MEIs are shown. The most
attractive investment open to the firm is the
renovation of its plant at a cost of Rs. 2
million. For this, the firm anticipates a rate
of return, or MEI, of 27 percent, which is
read from the vertical axis, the next most
profitable investment is the addition of a
new wing to its factory at a cost of Rs. 1
million, for which the MEI is 20 percent.
Each remaining investment project is
interpreted similarly.
If we assume that the risks of loss associated
with these investments are the same, the
descending order of MEI suggests two
things:
1. Fewer investment opportunities are
available to a firm at higher rates of return
than at lower ones. For example, it is harder
to find investment yielding 25 percent than
to find investments yielding 10 percent.
2. A firm will tend to choose those
investment projects which have the highest
MEIs. Therefore, a project with a higher
anticipated rate of return over cost is likely
to be selected over a project with a lower
one.
Figure 8.6 shows the solid stepped line as an
individual firm’s MEI curve. It shows the
amount of investment the firm will make at
various interest rates or cost of funds at any
given time. The MEI curve is then the firm’s
demand curve for investment. These are
many such stepped curves at any given time,
one for each firm in the economy.
Figure 8.7 shows the MEI curve for all
firms. It is a smooth line obtained by
summing individual MEI curves. It shows
the total amount of private sector investment
which will be made at various interest rates.
The MEI curve in this chart is the
economy’s aggregate demand curve for
private-sector investment.
Marginal Rate of Investment (MEI) # Cost
of Funds: The Rate of Interest:
Once the MEI (or rate of return) on an
investment is estimated, the next step is to
establish the cost of funds needed to finance
the investment. Only then can one decide if
the investment is worth undertaking. The
cost of funds needed to finance an
investment is expressed as a percentage.
Thus, if a business firm borrows money for
investment and agrees to pay an annual
interest charge of, say, 10 percent, then that r to r’, causing the amount of investment to
is the firm’s cost of funds. increase from I to I’.

Alternatively, if the firm uses its own

money, instead of borrowing, the interest
return sacrificed by not lending the money
in the financial markets (through the
purchase of bonds or other securities) may
be thought of as the company’s cost of
funds.

This cost of course is the opportunity cost of

funds. In any case, the MEI and the cost of
funds are each quoted as percentages.
Therefore, they can be easily compared.
This makes it possible to determine the
amount of investment which will take place.
Marginal Rate of Investment (MEI) # The
MEI and the Rate of Interest:
Figure 8.8 illustrates the relationship
between the MEI and the rate of interest in
deciding the amount of investment in the
economy at a particular time. In Figure (a),
the equilibrium rate of interest is determined
by the intersection of the demand and supply
curves of money—the IPC and M curves.
This rate is the cost of money capital to
firms. Hence in Figure (b), the amount of
investment undertaken by the business
sector at this rate of interest, shown by the
aggregate MEI curve, is I.
What happens if this volume of investment
is insufficient to achieve full employment?
In that case the monetary authorities can
lower the rate of interest by increasing the
money supply any from Q to Q’. Assuming
that the LPC curve remains fixed, the
equilibrium rate of interest will decline from
This increase in investment will have a
magnified effect on income owing to the
working of the investment multiplier.
Further, since the liquidity preference curve
(LPC) depends on income, it will shift to the
right when income rises. Thus, the effects of
monetary policy on investment and
employment depend on a variety of factors.
Marginal Rate of Investment (MEI) #
Criticism of the Marginal Efficiency of
Capital Concept:
Keynes’s concept of Marginal Efficiency of
capital has been criticized on two counts.
Firstly, it has been pointed out by A.P.
Lerner that what Keynes called MEC is
really efficiency of Investment and not
capital. Keynes’ MEC was a vague and even
ambiguous concept.
Secondly, Keynes failed to realise that
interest rates were as much governed by
expectation, as was the MEC otherwise he
would have considered the rate of interest to
be as much a dynamic clement as the MEC.
In fact, Keynes had recognised only partly
the role of expectations in his speculative
demand for money.
There is an indirect relationship between
investment and employment; that is, if the
investment increases, labor needs tend to
fall. Thus, a decrease in employment will
occur which will also affect the aggregate
demand.
Balance of Payments
The Balance of Payments is a record of a
country’s transactions with the rest of the
world. It shows the receipts from trade. It
consists of the current and financial account
1. Current account
This is a record of all payments for trade in
goods and services plus income flow it is
divided into four parts.
 Balance of trade in goods (visibles)
 Balance of trade in services
(invisibles) e.g. tourism, insurance
 Net income flows (wages and
investment income)
 Net current transfers (e.g. govt
aid)
2. Financial account
This is a record of all transactions for
financial investment. It includes:
Net investment from abroad (e.g. A UK
firm buying a factory in Japan would be a
debit item)
Net financial flows – These are mainly
short term monetary flows such as “hot
money flows” to take advantage of exchange
rate changes
Reserves
(note the Financial Account used to be
called the Capital Account)
3. Capital Account
This refers to the transfer of funds
associated with buying fixed assets such as
land
 Balancing Item
In practice when the statistics are compiled
there are likely to be errors therefore the
balancing item allows for these statistical
discrepancies.
Balance of Payments equilibrium
In a floating exchange rate the supply of
currency will always equal the demand for
currency, and the balance of payments is
zero.
Therefore if there is a deficit on the current
account there will be a surplus on the
financial / capital account.
If there was an increase in interest rates this
would cause hot money flows to enter into
the UK, therefore there would be a surplus
on the financial account
The appreciation in the exchange rate would
make exports less competitive and imports
more competitive therefore with less exports
and more imports there would be a deficit on
the current account.
Factors affecting balance of payments
A current account deficit could be caused by
factors such as.
1. High rate of consumer spending on
imports (during economic boom)
2. Decline in international competitiveness
making countries exports less
competitive
3. Overvalued exchange rates which makes
exports relatively more expensive
The balance of payments is the record of
all international financial transactions made
by a country's residents. A country's balance
of payments tells you whether it saves
enough to pay for its imports. It also reveals
whether the country produces enough
economic output to pay for its growth. The
BOP is reported for a quarter or a year.
A balance of payments deficit means the
country imports more goods, services and
capital than it exports. It must borrow from
other countries to pay for its imports. In the
short-term, that fuels the country's economic
growth. It's like taking out a school loan to
pay for education. Your expected higher
future salary is worth the investment.
In the long-term, the country becomes a net
consumer, not a producer, of the world's
economic output. It will have to go into debt
to pay for consumption instead of investing
in future growth. If the deficit continues
long enough, the country may have to sell
off its assets to pay its creditors. These
assets include natural resources, land and
commodities,
A balance of payments surplus means the
country exports more than it imports. Its
government and residents are savers. They
provide enough capital to pay for all
domestic production. They might even lend
outside the country.
A surplus boosts economic growth in the
short term. That's because it's lending money
to countries that buy its products. That
boosts its factories, allowing them to hire
more people.
In the long run, the country becomes too
dependent on export-driven growth. It must
encourage its residents to spend more. A
larger domestic market will protect the
country from exchange rate fluctuations. It
also allows its companies to develop goods
and services by using its own people as a
test market.
BOP Components
The balance of payments has three
components. They are the financial account,
the capital account and the current
account.The financial account describes the
change in international ownership of assets.
The capital account includes any financial
transactions that don't affect economic
output. The current account measures
international trade, the net income on
investments and direct payments. Here are
the balance of payments components and
how they work together.
Financial Account
The financial account measures
1) changes in domestic ownership of foreign
assets and
2) foreign ownership of domestic assets. If
foreign ownership increases more than
domestic ownership does, it creates a deficit
in the financial account. This means the
country is selling off its assets, like gold,
commodities and corporate stocks, faster
than it is acquiring foreign assets.
Capital Account
The capital account measures financial
transactions that don't affect a country's
income, production or savings. For example,
it records international transfers of drilling
rights, trademarks and copyrights. Many
capital account transactions happen
infrequently, such as cross-border insurance
payments. The capital account is the
smallest component of the balance of
payments.
Current Account
The current account measures a country's
trade balance plus the effects of net income
and direct payments. When the activities of
a country's people provide enough income
and savings to fund all their purchases,
business activity and government
infrastructure spending, then the current
account is in balance.
Current Account: Deficit
A current account deficit is when a country's
residents spend more on imports than they
save. To fund the deficit, other countries
lend to, or invest in, the deficit country's
businesses. The lender country is usually
willing to pay for the deficit because its
businesses profit from exports to the deficit
country. In the short run, the current account
deficit is a win/win for both nations.
But if the current account deficit continues
for a long time, it will slow economic
growth. Why? The foreign lenders will
begin to wonder whether they will get an
adequate return on their investment. If
demand falls off, the value of the borrower
country's currency may also decline. This
leads to inflation as import prices rise. It
also creates higher interest rates as the
government must pay higher yields on its
bonds.
Current Account: Trade Balance
The trade balance measures a country's
imports and exports. This is the largest
component of the current account, which is
itself the largest component of the balance
of payments. Most countries try to avoid a
trade deficit, but it's a good thing for
emerging market countries. It's helps them
grow faster than they could if they
maintained a surplus.
Current Account: What's a Trade
Deficit?
A trade deficit results when a country's
imports more than it exports. Imports are
any goods and services produced in a
foreign country, even if produced overseas
by a domestic company.
Therefore, a trade deficit can occur even if
all the imports are being sold by, and
sending profit to, a domestic firm. With the
rise of multinational corporations, and job
outsourcing, trade deficits are on the rise.