Keynesian Investment Function

Keynesian was a macroman...er, macroeconomist. The Keynesian investment function was part of his theory of macroeconomics, which dealt specifically with the idea of how firms decide to invest.

Keynes purported that businesses decide to invest in capital (equipment, machinery, land, etc.) when the marginal efficiency of capital (MEC) is greater than the (real) interest rate (r). When MEC is less than or equal to r, firms will won’t be investing and expanding.

What is this “MEC,” you ask? The marginal efficiency of capital is the rate of return expected from an income-earning asset...again, like a machine.

Firms are more likely to invest in equipment the more money it will make. If the interest rate of buying the equipment is higher than the MEC of it, it’s not worth the investment. If you bought a money-making machine, you wouldn’t pay more for it than it was going to make you, right? Then you’d be losing money.

Keynes believed that optimistic firm managers, technology, and a healthy, growing economy (i.e. people buying things) would increase the chances of firm investment. If firms have stockpiles building up...or if interest rates go up...then firms will be jumping off the caboose of the investment-train.