Keynes Monetary Theory on Rate of Interest and Investment (Explained With Figure)!
The second proposition in Keynes’ monetary theory is that the rate of interest influences the level of economic activity by first influencing the rate of real investment in the economy. The investment which Keynes talks of in the General Theory (1936) is investment in fixed capital or durable machines.
Since this is only a small part of total private expenditure, it is important to note that Keynes makes only this small part possibly responsive to changes in r and that he leaves out the rest from such consideration by assumption. This view has been contested strongly by Friedman (1972) and others.
To study the influence of the rate of interest on I. Keynes first analysed the ‘marginal efficiency of investment’ (MEI). The MEI is the expected rate of return from one more unit of investment. It is given by that rate of discount which makes the present value of the flow of expected income stream over the useful life of one more unit of investment (in, say, a machine) equal to the cost of investment in that machine.
This may be stated algebraically thus:
where Cm, = the cost of a machine,
Q = the expected income from the machine (gross of depreciation),
P= the rate of discount, and
n = the number of ‘years’ of useful life of the machine.
Cm and n are assumed to be given and Qs are assumed to be estimated by the investor. It is here that the factor of expectations enters the investment decision in a big way. When investors’ expectations about the future are rosy, they estimate Q liberally and the expected p from any investment gains in value. The reverse happens when gloom and pessimism overtake investors.
Given these expectations, Cm, and n, equation (13.3) is solved for that value of p which makes its two sides equal, it is assumed that p will have a unique value. Then, this value is the value of the MEI from a unit of investment under consideration. While making fresh investment, the investor is assumed to make the most profitable use of his funds. So, the investment chosen will be the one which promises the highest p. From equation (13.3) it can be seen that p will be a declining function of Cm and an increasing function of Q.
Keynes argued that both Cm, and Qs are affected by I — the former in the short period, the latter in the long period. In any short period, the supply price of machines was supposed to rise with increase in their production. Therefore, if I is stepped up leading to increased demand for machines, Cm will go up which will lower p.
So it was concluded that the MEI would be a declining function of I. For this result, it was additionally assumed that Q’s will stay unaffected, because the additional output of the new machines installed will be a rather small proportion of the total output.
In a longer period, however, the new machines installed will have accumulated to a large enough proportion of the total fixed capital in place; consequently, the competition of output from new machines will reduce the values of Q s.
In the long period, this may be a more important reason for the downward slope of the MEI function. The whole discussion is entirely heuristic and not firmly grounded in rigorous economic theory. The subject has not been improved upon since.
In the next step, the MEI function is converted into the investment demand (I”) function by imposing the condition that, in equilibrium, I will be carried to the point where its MEI is equal to r, determined in the money market. Thus, at each r there will be a determinate I given by the MEI function and the latter becomes the Id as a function, giving Id as a declining function of r (Figure 13.2).
In Figure 13.2 the downward-sloping MEI function shows MEI as a declining function of I or the equation
MEI = f(I), df/ dl< O
In this figure the same MEI line also represents Keynes’ I” function or the equation
dId /dr <O
The passage from (13.4) to (13.5) via the equilibrium condition MEI = r should be carefully noted. Note must also be taken of the difference between the two equations MEI = f (I), df/dI < O (13.4) and dId/ dr < O (13.5) in the former I is the explanatory variable, in the latter the dependent variable.
In the second proposition of Keynes’ monetary theory relating I lo r, the responsiveness of Id to changes in r (or the interest elasticity of Id) is the important thing. If is highly interest elastic, a given reduction in r will lead to a relatively large increase in I. which will have large expansionary effect on income. The interest elasticity of
Id is an empirical question. In Keynes’ empirical judgement, this elasticity is of rather low value. Most subsequent empirical studies have confirmed Keynes’ suspicion. This, then, is an additional reason why Keynes thought monetary policy to be a rather ineffective tool to fight depressions with.
Several economists do not share Keynes’ pessimism on this score either. The empirical support based on business questionnaires has been called into question. More sophisticated econometric analysis of the data does not lend unqualified support to Keynes’ hypothesis. It has been argued that investments with very long lives, such as houses and public utilities, are highly r-sensitive.
Then inventory investment to which keynes paid little attention is also found to be sensitive to changes in short-term rates of interest, which in turn are much more manipulable by monetary policy. Friedman (1963) has argued that beside the above items of investment, expenditure on consumer durables and even on non-durables is influenced by changes in the rate of interest. Therefore, by restricting his gaze to only one component of private expenditure, namely investment in durable capital equipment, Keynes underestimated grossly the influence of changes in r in the economy.