The Marginal Efficiency of Investment (MEI) is a concept in macroeconomics introduced by John Maynard Keynes, which measures the expected rate of return on an additional unit of investment. It represents the discounted future profits from a new capital asset relative to its cost. In simpler terms, MEI is the rate at which a firm expects its investment to yield profits over time. Investment decisions are guided by comparing MEI with the market interest rate: if MEI exceeds the interest rate, investment is profitable and likely to occur; if it is lower, investment is discouraged. MEI helps explain business cycles, fluctuations in investment, and aggregate demand, highlighting the sensitivity of investment to expected profitability and interest rates.
Features of Marginal Efficiency of Investment:
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Expected Rate of Return
The MEI represents the expected rate of return on an additional unit of capital investment. It is not a guaranteed return but a forecast based on anticipated profits over the life of the investment. Firms use MEI to compare potential projects and determine which investment is likely to be most profitable. The expectation depends on factors such as market demand, production costs, and future economic conditions. MEI emphasizes that investment decisions are forward-looking and based on predicted benefits rather than past performance, highlighting the role of business expectations in economic activity.
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Relation to Capital Cost
MEI is measured in relation to the current cost of capital. It is calculated as the discount rate that equates the present value of expected future profits from an investment with its cost. Essentially, it indicates whether the investment is worth undertaking. If MEI exceeds the market interest rate or cost of capital, the investment is profitable; if it is lower, it is not. This feature highlights the decision-making role of MEI, as firms invest only when expected returns justify the cost, ensuring efficient allocation of resources in the economy.
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Inversely Related to Interest Rate
The MEI has an inverse relationship with the prevailing interest rate. When interest rates are low, more investments become profitable because the cost of borrowing is reduced, increasing the volume of investment. Conversely, higher interest rates discourage investment, as the cost of funds may exceed expected returns. This feature explains why monetary policy and interest rate changes significantly influence investment decisions. MEI serves as a link between expected profitability and borrowing costs, determining whether firms expand or contract investment, and thus playing a central role in shaping aggregate demand and economic fluctuations.
- Dependence on Business Expectations
The MEI depends heavily on business expectations regarding future profits. If entrepreneurs expect high demand, rising prices, or cost advantages, the anticipated return on investment increases, raising MEI. Conversely, pessimistic expectations about market conditions, competition, or economic stability lower MEI. This feature highlights the psychological and forward-looking aspect of investment decisions, where uncertainty and optimism or pessimism significantly affect investment levels. MEI, therefore, is not purely mechanical but influenced by confidence, market trends, and economic forecasts, which explains why investment can fluctuate even when interest rates are stable.
- Role in Economic Fluctuations
MEI plays a crucial role in explaining business cycles and economic fluctuations. Variations in MEI influence investment, which is a key component of aggregate demand. When MEI is high, investment rises, stimulating production, employment, and income, leading to economic expansion. When MEI falls, investment declines, reducing economic activity and potentially causing recession. This feature emphasizes that investment decisions based on MEI are a major determinant of the economy’s overall performance, highlighting the importance of government policy, interest rates, and business expectations in stabilizing or stimulating economic growth.
Graphical Representation:
Inverse Realtionship:
As investment increases, the expected rate of return (or MEI) decreases. This reflects diminishing returns—each additional unit of investment yields a lower return than the previous one.
- Decision Point:Firms compare the MEI to the market rate of interest.
- If MEI > interest rate, investment is profitable.
- If MEI < interest rate, investment is not worthwhile.
- Economic Insight:The curve helps explain why businesses may reduce investment when interest rates rise, and increase investment when rates fall.
🧠 Real-World Analogy
Imagine you’re planting mango trees 🌳:
- The first few trees give great fruit.
- But as you plant more, the land gets crowded, and each new tree yields less.
- That’s MEI in action—each new investment gives lower returns.