|
Information > Financial Terms > This page Marginal Efficiency of Capital That
rate of discount which equates present value of net expected revenue from
an investment of capital to its cost; a Keynesian concept.
The concept plays a major role in the Keynesian theory of investment;
the level of investment is determined by the marginal efficiency of capital
relative to the rate of interest.
If the marginal efficiency rate is higher than the rate of interest,
investment will be stimulated; if not, investment will be discouraged.
A fall in the rate of interest will stimulate investment, assuming
the decline is below the given marginal efficiency rate.
Marginal efficiency returns should then rise (based on higher anticipations
of returns from investment), and such rise above a given prevailing rate
of interest will stimulate investment. The
concept is based on the ordinary mathematical technique of computing present
value of a given series of returns discounted at a specified discount
rate. If an investment in
equipment cost $4,450 and is expected to yield returns of $1,000 per year
for five years, such returns,
In
income-expenditure analysis, the marginal efficiency of capital is a price
factor in determining whether businesses are going to borrow and invest.
The rate of interest is a passive factor because businesses do
not borrow merely because the interest rate is low.
A stable and material gap between the marginal efficiency of capital
and the rate of return will result in an increase in the level of economic
activity. The
marginal efficiency of capital is determined to some extent by the expectation
of profits compared to the replacement cost of capital assets.
The marginal efficiency of capital can ordinarily be improved by
an increase in productivity, sales, or prices, or by a decrease in the
costs of production. Generally,
it is the relationship between the marginal efficiency of capital and
the rate of interest that causes expansion, equilibrium, or contraction
in the economy. The
term net expected revenue anticipations refers to net return over depreciation.
Productivity theories of investment and their justification of
interest date back at least to the work of the famous Austrian Bohm-Bawerk
and the early work of Dr. Irving Fisher of Yale, but in the Keynesian
schema the marginal efficiency of capital was adapted as one of the three
major aspects of the Keynesian model, the other two being the liquidity
preference concept of determination of interest rates and the consumption
function. |