Custom Search

Private investment depends less upon the rate of interest than on the overall level of economic activity. Discuss.

(Trying to really write in note form this time)

This question basically asks weather the MEC curve is more likely to hold and thus determines investment when interest rates change, or is the MEC curve so unstable that in reality there is not a proper one, so that other factors determine the investment level. Empirically it has been found that both factors have an influence, but they are not the only factors that have an effect n the investment. Investment is also very largely affected by business expectations about the future. They can think that the business cycle will affect their demand, or they can expect the future interest rates to be different from the present rates. Anyway, in order to make a completely subjective assessment about the relative importance of MEC and about the relative importance of economic activity in affecting the investment, I must first talk about them first.

MEC is the marginal efficiency of capital. Keynes used the term first. Marginal means the last unit. So marginal efficiency of capital is the amount the last unit brings in to the firm. It is calculated by taking the net present value of the extra investment. That is done by summing all the income over years that this last unit of investment brings. But there is also an opportunity cost associated with investing this capital - the interest (we assume that there is only one interest rate) foregone. So we cannot just sum the income this investment brings, we have to discount it to present value. If interest rate is 10% then 100 quid will be 110 next year. Inversely, if the investment will bring in 110 pounds next year, with interest 10%, then these 110 pounds is only worth 100 pounds this year(100 pounds this year could be invested this year to yield 110 pounds). So firms will discount their income stream, they assume interest will not change, and use the compound interest rate formulae to calculate the present value of the future profits:


†† ((income at time i)/(1+r)i) = present value


r - interest rate, assumed that machine is worthless after n time periods. If it could be sold after n periods at price p then the formula is

††††††††††††††††††††††††††††††††††† i=n

present value = ††††††††††† †† ((income at time i)/(1+r)i) + p

††††††††††††††††††††††††††††††††††† i=1

The investment will go ahead if the present value is greater than the cost of investment. Keynes assumed of diminishing returns. That means as more investment is made the less profitable the extra investment becomes. Firms will invest as long as it is profitable for them - as long as the last unit of investment is profitable, or its present value is just equal to its cost (so that normal profits are earned). If interest rate falls it is seen from the formulae that the present value will rise with the future income remaining constant. So more investment becomes profitable. Keynes took the accountants' view. He said that as investment rises it will be less profitable, because of two reasons. First the product you are investing in has a downward sloping demand curve, as more is produced price must be lowered in order to sell it and thus marginal revenue of producing last units decreases. Another reason is that the price of capital is bid up when more investment occurs and thus it becomes more expensive to invest.

We can depict the MEC curve now. It is the inverse relationship between investment and interest rate:

Keynes did do a small mistake here. Capital usually denotes the whole capital stock, whereas Keynes here is talking about the flow of capital, that is called investment.

According to this graph as interest falls more investment is made and vice versa.

But investment decisions are rarely marginal. I.e, firms cannot say that the last 100 pounds of a 10000 pounds' investment they cannot think this brings in 7%, they are more likely to think it will bring between 5-10%. So once they have thought they will not go for it with 5% interest they will not invest with 6% either. Here is the other weakness. In real life the base interest rate is changed by the bank only by a small amount, perhaps 0.25%. This will not affect investment much. There is also not only a single interest rate but several and it depends on the availability of credit whether a firm can get a loan with the lower interest rate.

Firms' expectations of the future r will also change, so we cannot just keep the r constant over time. Keynes called this the animal spirits of investors. This will shift the MEC curve. There are also problems with capital gains and bonds (bonds value will increase if rates fall and that might affect firms' investment decisions). This MEC curve only talks about the desirable stock of capital (i.e. total investment done over time). It does not explain the speed of investment, this is discussed in the next point of the essay.

As a conclusion the rate of investment affects more the money flows in and out of the economy, not the real investment as the rate changes are only marginal.

Now about the economic activity level. This view says that as the level of aggregate demand rises, assuming the constant optimal capital to labour ratio, firm will need more capital suddenly. But the capital stock is much greater usually than the amount that depreciates, thus the stock is much grater than the flow of normal investment taking place all the time. Furthermore, capital brings returns over time, and it is thus most of time more expensive to build than the returns on its first time period. So basically because of all this, when the demand for capital increases by 10%, because aggregate demand has risen by 10%, investment must rise much more than 10% to produce that extra 10% of capital. It is assumed that if one invests more, then it becomes more expensive (shortage of raw material, people working overtime to install the machinery and to make up the output lost while the factories were not working due to installing of new machines) (Jugend). Firms would like to invest all this 10% of capital immediately in order to produce optimally, but as this is expensive they instead use more labour intensive producing methods in the short run and will raise their investment less sharply (distributed lags). This is the same thing as accelerator model (it says investment depends on the level of change in GDP not the absolute level).

This model also explain the cyclical nature of the economic growth, because when aggregate demand (AD) rises and extra investment occurs this will create (through the multiplier effect) extra artificial increase in the AD which would stimulate investment even further, so the economy overshoots in investment and has too much capital to be effective. So it has to get rid of some. But it cannot just scrap it - it can only stop all investment to new capital, and let its capital to depreciate. This stop in investment will again have a multiplier decreasing effect on demand. But the firms will have increased stock during the period they had too much capacity, they have to sell this stock. So producing capacity falls to low, because firms will be selling off their stock and do not want to start the investment too early.

So it seems to me, without any empirical evidence, that accelerator model does not have any major criticism, only modifying factors like the firms learning from experience (rational expectations), whereas there are severe doubts about MEC model.

Does the success of the "Q" theory in explaining investment make the accelerator model redundant.

Accelerator model is the same as the model by which private investment depends upon the level of economic activity discussed in previous section. Q theory is the newer theory developed by Tobin. It basically says the investment depends on the difference between the value of the firm when sold and the value of the firm in the stock market - the more does the stock market value the firm the higher its investment. These theories are not mutually exclusive, they overlap, but they are not exclusively the same thing. Q theory is not meant for solely predicting investment. Investment can be empirically tested in Q model only if a number of restrictive assumptions are made. On the other hand if Q theory holds it should explain 100% of investment movements, but there is significant correlation between the growth of output and the investment as well (supporting the accelerator view).

So in order to find out whether the q theory is better is explaining the overlapping areas, I must first give a summary of the theory, based on Hayashi and Tobin.

As I said Q=firm value in the City/firmís asset values. So the investment will depend on the value of firms' capital, but also on the Cityís attitudes, risk spreading etc. Classical dichotomy does not work quite with the Q theory as investment decisions are not based on interest rates and this theory implies a strong link between real IS and monetary LM sectors of the economy.

Older versions of Q theory said that each asset has its own Q, because financial assets were imperfect substitutes. Valuation of physical assets relative to replacement costs will also change. Newer versions have concentrated on the question why are arbitrageurs not eliminating all the imperfections from the returns of physical and financial assets. Solution is that it takes time to replace physical assets and it requires costs - adjustment costs(AC). They are square function of investment - they rise relative to investment, because as more investment is undertaken more machines have to be temporarily stopped and it is harder to train the labour to use them.


That also says that adjustment costs are decreasing as the existing capital stock increases, because of the economies of scale and availability of cheaper credit etc. Abel and Lucas have put together an optimising equation for the Q theory derived from the Eulers optimisation:

I/K~expected income from the extra investment/purchase price of investment goods(p).

Here it is clearly seen that the adjustment costs and the optimising output are different and that gives rise to distributed lags.

The expected income is the income entrepreneurs expect to receive from the investment defaulted to the present value. It is very hard to find in the reality. Writers have found that if one makes assumptions about the market, namely that is perfect; that all capital is homogeneous and that capital depreciates geometrically then the right hand side of the last equation is Q. If we define the value of the firm (V) = expected income from the capital x capital, then Q=V/pK and I/K=Q

This result is quite important, despite the fact that the empirical studies do not support it very well. Q follows from the optimisation process, unlike the neo-classical model, it does take expectations into account (by using stock market data) and it is also a very intuitive result, already suggested by Keynes. Basically it says there is no point in investing if the assets are worth more separately then the firm in the stock market, or conversely, enormous investments are made if they can be floated in the stock market easily.

However, besides the poor empirical evidence, the adjustment costs are also unreasonably high, as is suggested by empirical studies. But the main reason why the empirical evidence is poor is that the firmís intangible assets are not taken into account. There is no way to do that at present.

Q theory is more important in the microeconomics level in determining the investment. However there is significant correlation between the investment and the growth rate of the economy, so the accelerator theory is not redundant.

My own view. Let us look at the difference between the stock market value and the real value of the firms' assets. This difference is mainly made up of two things: the expected rise in profits of the firm and its intangible assets. Very few firms have negative intangible assets (i.e. very bad reputation), but their profits can be expected to rise. There is a very complicated theory that predicts the future profits. If these predictions are used one can calculate the intangible assets of the firm. If we add that to the tangible assets we should get much higher empirical evidence in investment and Q relation, because for sure Microsoft is much more willing to advertise and invest on other things than Cambridge computers, meanwhile the real values of the two firms are not that different for sure!

Is there a capital shortage in the UK?

The concerns about the capital shortage have come because the capacity utilisation in the UK has exceeded 90% sometimes. At the same time the UK still has a high unemployment. The rate of investment has also been depressed in the UK for last 10 years, as Bean claims.

So some people fear that in the event of recovery there is not enough capital to absorb the unemployed and raise national income. Instead inflation will occur and balance of trade will go into the red. Bean calls this the capital gap and suggests that investment needs to rise by about 20% compared to 80's level, in the event of recovery.

However the pre-war USA experience suggests that the investment can rise rapidly when it is profitable, so there is no market failure. 20% rise would only represent the return to 70's investment level. There is only a possible problem in the short run, but then firms can go to more labour intensive production levels.

Furthermore, the labour market adjustment is like to take much more time than the increase investment. The trade unions are slow to change their policies. AT the present England has the insider-outsider problem - many long-term unemployed have accepted outsider view and do not search for the job actively. So it takes longer time to recruit and train the extra people that it does to increase investment. So England is unlikely to have a capital shortage at present, it is more likely to be using the most cost effective ways of production when it has utilised the capital to 90%.

Click here to see more economics,politics and school papers from me