A Graphic View of The MEI
According to the Keynesian approach, there is a systematic relationship between the rate of interest and the amount of investment that can be profitably undertaken at a particular time. This relationship is called the Marginal Efficiency of Investment. To repeat:
Since businessmen are rational profit-seekers (we assume) they will invest in just those projects, and only those projects, that are profitable at the given rate of interest. In general, this will be an inverse relationship -- the higher the interest rate, the less investment.
The idea of the Marginal Efficiency of Investment, and the inverse relationship, are illustrated by the following example. Think of a very small economy in which just five investments are being considered. The five are shown in Table 3, below. Column one enumerates the five investments from the most to the least profitable.
| Project | Investment Cost |
Internal Rate of Return |
Total Investment |
|---|---|---|---|
| Shoe Factory | $10,000,000 | 12% | $10,000,000 |
| Bottling Plant | $12,000,000 | 10% | $22,000,000 |
| Distillery | $8,000,000 | 9% | $30,000,000 |
| Hydro Plant | $20,000,000 | 5% | $50,000,000 |
| Subway System | $900,000,000 | 1% | $950,000,000 |
The second column shows the amount invested in each project separately, the third column shows the rate of interest at which that project will break even, and the last shows the running total of investment. What we see is that the lower the interest rate, the more of the projects can be profitably undertaken, so the more total investment we see in the last column. The last two columns, taken together, define the marginal efficiency of investment for this small economy.
A Graphic View of The MEI
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