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4. The hypothesis ignores the role of expectations in investment decision making. If investors expect a positive change in aggregate demand to be temporary, such increase might not elicit investment spending from them. However, an optimistic business outlook would make businessmen increase their investment outlay consequent upon an increase in aggregate demand (income).

SELF-ASSESSMENT EXERCISE

Explain the two versions of the acceleration hypothesis.

As a matter of fact, the MEC is the expected rate of return over cost of new capital goods. In order to find out whether it is worthwhile to purchase a capital good, it is essential to compare the present value of the capital assets with its cost or supply price. If the present value of a capital good exceeds it cost of buying, it pays to buy it. On the contrary, if its present value is less than its cost, it is not worthwhile investing in these capital goods.

The same results can be had by comparing the MEC with the market rate of interest. If the MEC of a capital asset is higher than the market rate of interest at which it is borrowed, it pays to purchase the capital assets, and vice-versa. If the market interest rate equals the MEC of the capital assets, the firm is said to possess the optimum capital stock. Thus the equilibrium condition for a firm to hold optimum capital stock is where the MEC and the rate of interest are equal.

MEC/

Interest r1

Rate r2

MEC 0 K1 K2

Fig. 2.1: The MEC Curve

The Figure above shows the MEC curve of an economy. It is negatively slope which indicates that the higher the MEC, the smaller the capital stock. This is because of the operation of the law of diminishing returns in production. In the figure, when the capital stock is 0K1, the MEC is 0r₁. As the capital increases from 0k₁ to 0k₂, the MEC falls from 0r₁ to 0r₂. The net addition to the capital stock K₁ K₂ represents the net investment in the economy.

Further, to reach the optimum (desired) capital stock in the economy, the MEC must equal the rate of interest. If, as shown in the figure, the existing capital stock is 0K1, the MEC is 0r1 and the rate of interest is 0r₂. Everyone in the economy will borrow funds and invest in capital assets. This is because the MEC (0r₁) is higher than the rate of interest (at 0r₂). This will continue till the MEC (0r₁), comes down to the level of the interests rate (at 0r₂). When the MEC equals the rate of interest,

the economy reaches the level of optimum capital stock. The fall in the MEC is due to the increase in the actual capital stock from 0K₁ to the optimum (desired) capital stock 0K₂. The increase in the economy’s capital stock by K₁ K₂ is the net investment of the economy. But it is the rate of interest which determines the size of the optimum capital stock in the economy. And it is the MEC which relates the amount of desired capital stock to the rate of interest. Thus, the negative slope of the MEC curve indicates that as the rate of interest falls, the optimum stock of capital increases.

The marginal efficiency of investment (MEI): The MEI is the rate of return expected from a given investment on a capital asset after covering all it costs, except the rate of interest. Like the MEC, it is the rate which equates the supply price of a capital asset to its prospective yield. The investment on an asset will be made depending upon the interest rate involved in getting funds from the market. If the rate of interest is higher, investment is at a low level. A low rate of interest leads to an increase in investment. Thus, the MEI relates the investment to the rate of interest. The MEI schedule shows the amount of investment demanded at various rates of interest. That is why; it is also called the investment demand schedule or curve which has negative slope as shown in Figure 3.4 below:

Fig. 2.2: The MEI Schedule

At 0r1 rate of interest, investment is 0I¹. As the rate of interest falls to 0r₂, investment increases to 0I^1I (panel A). To what extend the fall in interest rate will increase investment depends upon the elasticity of investment demand curve of the MEI curve. The less elastic is the MEI curve, the lower is the increase in investment as result of fall in the rate of interest, and vice versa .

In Figure 3.4, the vertical axis measures the amount of investment; the MEI and MEI^I are the investment demand curves. The MEI curve is panel (A) is less elastic, so investment increases by I^II^II which is less than the increase in investment I₁I₂ shown in panel (B) where the MEI^I curve is elastic.

Shortcomings of the marginal efficiency theory

(1) It does not give explicit recognition to the role of expectations in investment decisions making. Yet the role of expectation is important in an attempt to capture an investor’s view about the probability distribution of the possible stream of returns

(2) Eisner and Strotz (1963) argued that the determinant of the internal rate of return that is used in discounting the stream of returns to their present value equivalent is both subjective and ambiguous. This criticism is of particular relevance in underdeveloped economies characterised by underdeveloped and imperfect capital market.

(3) The concept of the “market rate of interest” is questionable. This is because what exists in practice and especially within the context of underdeveloped capital market is not the “market rate of interest” but a series of interest rates namely Lending rate, Minimum Rediscount Rate, Treasury Bill Rate etc. The difficulty of accepting any of these rates as optimal in the context of deregulation of interest rate as we have in Nigeria is even more fundamental. It is in cognisance of this that Ott, et al. (1975) caution that investors exercise cares in selecting the rate of interest they compare to MEI.

SELF-ASSESSMENT EXERCISE

Explain the marginal efficiency theory and the shortcomings therein.

3.3 Relationship between the MEC (Capital stock) and the