Broadly speaking, investment depends on the marginal efficiency of investment and the rate of interest. What induces individuals to undertake investments? Obviously, profit expectations seem to exercise a major influence on the investment decisions of individuals, and these profit expectations in turn are influenced by the current and the expected level of economic activity, changes in technique and so forth.
Suppose a man borrows money to invest. He will have to pay interest on the loan. But he expects profit from this investment. He must compare the rate of interest he has to pay to the rate of profit that he expects to obtain. Obviously, the rate of return or profit must at least be equal to the rate of interest; otherwise no investment will be made. So long as the expected rate of profit exceeds the rate of interest, investments will continue to be made. The yield expected from a new unit of capital is called the marginal efficiency of capital. This marginal efficiency of capital must never fall below the current rate of interest, if investment is to be worthwhile.
The rate of interest does not quickly change. Hence, the inducement to invest, by and large, depends on the marginal efficiency of capital. If the business expectations are good or if the marginal efficiency of capital is high, more investments will be made in spite of high rates of interest. On the contrary, a depression, or bleak prospects of profits, will discourage investment, even if the prevailing rate of interest is low. Thus, fluctuations in investment are mainly due to the fluctuations in the marginal efficiency of capital. There are some other factors that affect investment. For instance, if a firm has excess capacity and can easily handle increased future demand, it will not go in for further investment to increase its capital equipment.
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