Shift in Marginal Efficiency of Investment Curve

Here we detail about the five factors that cause shift in marginal efficiency of investment curve.

The five factors are: (1) Business Expectations and Animal Spirits, (2) Technology and Innovations, (3) User Cost of Capital, (4) Availability of Credit, and (5) Fiscal Policy.

Factor 1# Business Expectations and Animal Spirits:

The Keynes theory gives importance to profit expectations of businessmen for determining marginal efficiency of capital in the economy. It is worth mentioning here the concept of animal spirits of Keynes. Keynes pointed out that it was not possible to make accurate calculations about the future profitability of investment.

He believed that the swings of optimism and pessimism of the business class were more important driving forces in the stock market that determine investment. It is these swings of optimism and pessimism about future profitability of investment which he referred to as animal spirits. According to Keynes, it is these animal spirits more than the economic fundamentals that determine investment by business firms.

However, marginal efficiency of investment by a business firm depends to a large extent on the demand it anticipates for its product. For the economy as a whole the marginal efficiency of investment (i.e., expected net return on investment) depends significantly on the consumption expenditure of households on the products produced in the economy.

Apart from income, consumption expenditure on goods and services depends on several factors such as propensity to save of the people, price level, rate of interest, stock of wealth, taxation policy of the government. Changes in these factors would cause a change in consumption of households and demand for the products. As a result, expected rate of return on investment i.e. MEI will change.

Marginal efficiency of investment which depends on prospective yields from investment in capital goods which are used in the production of certain products depends on expected demand for these products. The prospective yields also depend on expected monetary and fiscal policies of the government and stock market situation etc.

Changes in them will change the marginal efficiency of investment and result in shift in investment demand curve. In what follows we first analyses the factors that cause changes in marginal efficiency of capital which bring about a shift in the investment demand curve.

Factor 2# Technology and Innovations:

In the recent years advances in technology and introduction of new products and processes have been important determinants of investment. The introduction of new improved technology and new products makes it necessary to build new plants or install new capital equipment. This stimulates investment in new capital goods.

An important recent example of this is the introduction of micro-computers for use in various fields of industries and services. This has spurred new investment in computers and other related equipment’s. Another important recent example is the introduction of mobile cellular telephones which has boosted investment in telecommunications by business class.

In addition to the above, advances in technology and new inventions make investment more productive. Increase in productivity of capital causes the firms to invest more at a given rate of interest. As a result, curve of marginal efficiency of capital shifts to the right.

Factor 3# User Cost of Capital:

The user cost of capital also greatly influences the rate of return on capital. The user cost of capital depends on the real rate of interest, rate of depreciation, corporate income taxes, investment tax credit, if any. The lower the real rate of interest, lower corporate income taxes, higher investment tax credit, the lower will be the user cost of capital which will increase the rate of return on capital and stimulate investment.

On the other hand, the higher the real rate of interest, the higher corporate income tax will discourage investment and shift the curve of marginal efficiency of capital to the left. It may be noted that real rate of interest is the nominal rate of interest minus expected rate of inflation.

Factor 4# Availability of Credit:

Besides cost of credit, availability of credit also determines investment in the economy.

Investment is financed in three ways:

(1) Borrowing from the banks and other financial institutions,

(2) Raising resources through issue of equity capital, that is, selling shares in the stock market, and

(3) Internal savings of the companies (i.e., retained earnings of the companies).

If the Central Bank of a country follows tight monetary policy [i.e., higher bank rate, the higher cash reserve ratio (CRR)], credit availability for investment will be less which will discourage private investment. If the Central bank adopts expansionary or easy monetary policy, credit availability from banks increases which is likely to encourage investment.

Factor 5# Fiscal Policy:

Fiscal policy of the Government, especially expenditure and taxation policy of it, can work in two ways. If Government increases investment and finances it by borrowing from the open market, this will raise the rate of interest which will crowd out private investment.

However, if expansionary monetary policy is adopted simultaneously, rate of interest will not rise and therefore crowding out effect will not occur. But there are beneficial effects of expansionary fiscal policy of the Government as well. Increase in Government expenditure, say on infrastructure such as power, communication, highways, roads, will raise the incomes of the people which will through the multiplier effect cause a significant increase in aggregate demand for goods produced by the private sector and raise the profit expectations of business firms.

This will encourage private investment. Many Indian economists believe that increase in Government expenditure, especially if it is made on infrastructure projects, crowds in private investment rather than crowds it out.