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The Keynesian Theory of Investment (With Diagram and Example) Page 1 of 12
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The Keynesian
Theory of Investment
(With Diagram and
Example)
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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).
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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 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.
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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 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.
If expectations change and investors expect

to receive better returns from each
investment — because, for example, of
technological progress — then at any given
rate of interest such as 20%) more
investment will be undertaken than before;
that is, the marginal efficiency of capital
schedule will shift to the right, as shown in
Fig. 18.1(b), and investment will increase

from OI2 to OI0.
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
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.
Factors Determining Investment:
Anything which increases a firm’s 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 firm’s

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
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 India’s 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 society’s 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:
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.
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 profit- maximising behaviour of a firm
under perfect competition. It is to this theory
to which we turn now.
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The Keynesian Theory of Investment (With Diagram and Example) Page 1 of 12

Download PDF (Free)

Let us make an in-depth study of the

According to the classical theory there are

According to Keynes investment decisions

So long as the MEC is greater than r, new

However, as more and more capital is used

Marginal Efficiency of Capital:

The MEC is the rate of discount which

and the rate at which these are expected to

If all possible projects in an economy are

The MEC is the rate of return (profits) on an

later investments are less productive and

The amount of investment undertaken

If the supply price of capital goods changes

It will be readily apparent from Fig. 18.1 that

If expectations change and investors expect

Fig. 18.1(b), and investment will increase

The MEC is calculated by using the

where C0 is the purchase price of the

from the machine in the last year which also

It may be noted that e varies directly with r

The term R is called by Keynes the expected

2. Suppose you have an opportunity to

market rate of interest is 10%, is it to your

Factors Determining Investment:

Anything which increases a firm’s profit

The following factors affect a firm’s

(i) Increased optimism among

If managers are more optimist about the

(ii) An increase in the growth rate of

Keynes assumed that all investment is

national or per capita income. However,

If India’s growth rate (as measured by the

In other words, there will be more demand

(iii) An increase in capital stock:

An increase in society’s stock of capital — all

the prospective rate of return on new

(iv) A change in technology:

A favourable technological change (not an

(v) Changes in the rate of interest:

Economists differ in their views about the

Thus the Keynesians economists claim that

So even small changes in interest rates will

monetary policy will be effective in

However, the neo-classical economists such

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