Keynes’s Expertise Guide to MEC and Trade Cycle of Investment

This article provides Keynes’s expertise guide to MEC and trade cycle of investment.

Keynes’ particular views on trade cycles revolve round the propensity to consume, state of liquidity preference, and the marginal efficiency of capital. The last factor occupying the maximum importance.

In his (Keynes) own words:

“A Trade Cycle is composed of periods of good trade characterized by rising prices and low unemployment percentages, alternating with periods of bad trade characterized by falling prices and high unemployment percentages.”

Thus, according to him, a trade cycle implies a fluctuation in business activity and fluctuations in price levels. It is quite evident that Keynes never developed any distinct theory of trade cycle in his book as Prof. Metzler points out, “The pure theory of trade cycle or business cycle was never one of Keynes primary interest”.

His explanation of the trade cycle is merely ancillary of the natural corollary of his theory of employment in which consumption function plays an important part. The real contribution of Keynes to the theory of trade cycle lies in his analysis of the explanation of the turning points, the lower as well as the upper turning points of these turning points marginal propensity to consume being less than one is the chief cause.

Keynes, however, felt that business cycles were more characteristic of the nineteenth century than they are of the twentieth century. His ideas as to the tendency of the secular decline in the MEC are to be noted, which imply that in highly advanced capitalist countries of the West, there is no question of alternative movements of full employment and unemployment, rather there is a chronic tendency towards a deficiency of demand or depression in the future due to the operation of factors like the declining population growth, tremendous accumulation of capital, decreasing investment opportunities and limits of colonisation.

According to him, business cycles as such may not be so important in future as the threat of secular stagnation. As Prof. Dillard agreeing with him has put it, “The threat of secular stagnation has replaced the business cycle as the major problem of economic policy”.

The essential of Keynes discussion of the trade cycle can be summed up as follows:

1. According to him, the trade cycle consists primarily of fluctuations in the rate of investment.

2. Fluctuations in the rate of investment are caused mainly by fluctuations in the MEC.

3. Fluctuations in the rate of interest have no doubt played a role but more typically these are the changes in the liquidity preference schedule (induced by the changes in the MEC) which reinforce and supplement the phenomenon.

4. Changes in the MEC are due to the changes in the prospective yield of capital goods and changes in the replacement cost of capital goods.

5. In a boom, the decline in prospective yield on capital is due, in the first instance, to the growing abundance of capital goods.

6. In the absence of thoroughgoing measures (monetary and fiscal, particularly fiscal) a variable rate of interest may prove useful as a means to stabilize the cycle. But Keynes preferred to maintain a low rate of interest in conjunction with other more radical measures designed to stabilize the cycle.

According to Keynes, even boom time levels of investment have failed to produce full employment, thus in order to achieve sustained full employment, it is not even enough to keep the boom going, and therefore, merely to choke off the boom by an increase in the rate of interest—this belongs to the species of remedy, which cures the disease by killing the patient. Thus, in the language of ‘General Theory’, the ‘business cycle is essentially a fluctuation in the marginal efficiency of capital, relative to the current rates of interest.

It begins with something that increases the attractiveness of investment, “a new invention, or the development of a new country or a war or a return of business confidence as the result of many small influences tending the same way”, and proceeds to that general increase in the volume of income and employment, which is brought about by the operation of multiplier in Keynes’ model. The expansion that starts depends upon the co-operation of the banking system which makes the supply of new money and credit available.

It is further stimulated by the inflation of prices and profits that this new money causes under these stimulating circumstances, boom may go on to considerable length even to the level of full employment of resources, but as the time goes on, various discouraging factors come into play which put effective brakes on further expansion.

Control of MEC:

It is, thus, clear that investment in an economy cannot be left entirely in the hands of private businessmen as they are entirely guided by the expected rate of profitability. Since MEC fluctuates a lot, it also causes fluctuations in private investment. In order to ensure stability in the economy, fluctuations in the private investment must be controlled.

Therefore, the State, which is in a better position than private enterprise to fulfill the long-term needs of the people, should assume greater responsibility by directly organizing investment. In other words, Keynes advocated ‘socialization of investment’ to overcome the fluctuations in the MEC. However, Keynes was never in favour of complete nationalization of investment; by this type of policy, he simply meant to supplement private investment with public investment.

Keynesian public investment economics has had enormous practical success. Many countries prepare in advance programmes of public investment to meet the recession if, as and when, it develops. Thus, if private investment which is highly sensitive to MEC falls off, its declining effects on demand may be offset by an equivalent addition of public investment. Keynes and his followers have provided a rationale for a full employment public investment policy so simple, so clear and so convincing that few democratic governments can overlook its adoption, specially when all is no longer quiet on the employment front.

Reflections on MEC:

It has been pointed out by critics that the whole concept of MEC as given by Keynes is vague and inconsistent. Prof. Hazlitt points out that Keynes used the term in so many senses that it becomes difficult to keep track of them. He did not adhere to any fixed meaning of the concept. Amongst the terms used like marginal productivity, yield or utility or efficiency of capital, Keynes used the vaguest of all, namely, efficiency of capital.

Keynes did not recognize the fact that the rate of interest was as much governed by expectations, as was the MEC. Thus, Keynes thought MEC to be an element of dynamic economics and the rate of interest to be an element of static economics.

According to Saulnier, the concept of MEC is defective as an analytical device because Keynes’ analysis of investment function is related to the interest and MEC on the presumption that wages equal the marginal productivity of labour. But if this assumption is dropped, the rate of wages becomes more important element in the theory^..Keynes has constructed a concept of the MEC as a whole. But Saulnier feels that the most useful data for economic analysis are those concerning the expected returns on capital investments in different sections of the economy. In an imperfectly competitive market it has special significance.

Saulnier further points that in Keynesian analysis there is no sufficient explanation as to the determination of the shape of an aggregate-investment demand schedule because there is no discussion of the economies (or diseconomies) which might influence the shape of the investment demand schedule. Thus, according to Saulnier, Keynes’ analysis is not complete, nor is the theory as expressed a satisfactory explanation of the factors which determine the productivity of capital.

We know that with a decline in MEC (given the rate of interest) investment also declines. On the other hand, as the economic system advances and people grow richer, the supply of resources for investment increases. It is here that the private enterprise fails us and the role of the State becomes significant to prevent a collapse of confidence, MEC and capitalism. Economic policies under such circumstances are directed not towards preventing a collapse in the state of expectations, on which MEC is based—rather these are directed towards helping the businessmen to formulate them in a definite manner.

Thus, the basic fault of the Keynesian policy of MEC in a system of private enterprise lies in the assumption that businessman can always arrive at a correct estimate as regards future and all that needs to be done is to so adjust the economic factors that he enjoys a reasonable volume or profits. Now, this may perhaps be true for certain countries (say advanced economies) and for certain situations; whereas in other countries (low income economies) and in other situations, a sensible economic policy may have to start with the assumption of a state of suspense rather than with a clear state of expectations (as is usually the case in developing economies).

Thus, those who argue that increased consumption in the present would automatically lead to increased investment in future. It may be pointed out that increment or decrement of investment at the margin is possible only in a situation where a definite state of expectations is possible and since such a situation does not exist in certain areas (in backward economies); we should first cause the emergence of a definite state of expectations in these areas and then increase the propensity to consume and not the other way round (i.e., first causing an increase in the propensity to consume and then improve the state of expectations through it).

Actually it is the wrong policy of increasing the propensity to consume in low income countries to have favourable expectations and high MEC for investment which has led to wrong consumption priorities (using luxury goods without acquiring the Necessities of life) without in any way creating favourable climate or expectations for investment. As a result, investment has been diverted to wrong channels.

It is, therefore, clear that under the changed circumstances prevailing in the countries of the world today, it will be unwise to think of like the earlier decades, that the entrepreneur’s willingness to invest is a factor that unquestionably exists or that willingness (MEC) is dependent only on some kinds of profits at present or future. There are deeper factors involved which are as much political or social in nature as they are economic. Thus, capitalism at least needs help so that a definite state of expectations could be formed. Hence, MEC and its estimate or its use as a policy device is not that simple as Keynes would like us to believe.