Investment and The Rate of Interest

Readers Question: Could u pls explain to me how the volume of private investment depends on the rate of the interest and marginal efficiency of capital?

Private investment is an increase in the capital stock such as buying a factory or machine. (investment in this context does not relate to saving money in a bank.)

When firms and individuals decide how much investment to make interest rates and marginal efficiency of capital are important.

Interest rates. If interest rates are high then it makes it expensive to borrow money. This will deter investment because investment is often financed through borrowing. Also when interest rates are high it makes it more attractive to save money. Investment is often financed out of retained profit. High interest rates mean that investment is relatively less attractive than saving money in a bank.

• Assuming inflation is zero, and interest rates are 3%. Then any investment project would need an expected rate of return of at least greater than 3%. If interest rates were 6%, then any investment project would need an expected rate of return of at least greater than 6%, and therefore less investment would occur.

The Marginal efficiency of Capital

The marginal efficiency of capital refers to how much investing in capital increases output. Specifically it refers to the annual percentage yield earned by the last additional unit of capital.

• If the marginal efficiency of capital was 5% and interest rates were 4%, then it is worth borrowing at 4% to get an expected increase in output of 5%.
• However, if the marginal efficiency of capital is less than interest rates it is not worth investing.

• Guide To Investment