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Lecture 5

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ECON 1010
Sarrah Vakili

Lecture 5: The marginal efficiency of capital (MEC) – the demand curve for investment Expected rates of return on investment matter when businesses are making investment decisions and this is where the concept of the marginal efficiency of capital comes in. The marginal efficiency of capital (MEC) is defined as the rate of interest which makes a proposed investment project viable “at the margin”. This is illustrated in the diagram above. At lower rates of interest (i.e. R2 rather than R1) more capital projects appear financially viable because the cost of borrowing money to finance the investment is lower and the opportunity cost of using retained profits as an internal source of investment finance is also reduced. A fall in interest rates should (ceteris paribus) lead to an expansion along the investment demand curve. Similarly higher interest rates (R3) may lead to some projects being postponed or cancelled. The limited statistical evidence available for the UK is that the demand for new capital goods tends to be interest inelastic i.e. there is only a weak link between changes in interest rates and fluctuations in planned capital investment by businesses. Partly this is because many firms prefer to use the capital market through the issue of new shares and bonds to raise funds for investment rather than relying on bank loans. That said, the rate of interest can and does affect capital investment decisions – perhaps through its effect on business confidence and also expectations of changing demand and the links between interest rates and the exchange rate. So a period of lower interest rates might stimulate more investment because of expectations of rising consumer demand and a lower exchange rate which will boost export demand Real Interest Rate Changes in business confidence, the costs of capital and demand lead to shifts in the investment demand curve. For example, an increase in export sales overseas might be an increase in the expected rates of return on capital investment and thus an outward shift of the investment demand schedule. The Accelerator Model of Investment This is another theory of investment. Put simply
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