Question

Review financial theory of investment.

Answer 1

The financial theory of investment explains investment decisions based on the relationship between the Marginal Efficiency of Capital (MEC) and the rate of interest (ROI). Entrepreneurs compare MEC, the expected rate of return from an investment, with the ROI, the cost of borrowing money. Investment increases as long as MEC exceeds ROI, while a higher ROI than MEC discourages investment. Equilibrium investment is reached when MEC equals ROI. Keynes and Post-Keynesian economists emphasize the importance of MEC over ROI in determining investment levels.

The theory also highlights that investment is financed primarily through savings, which flow from households to firms via financial institutions. Investment acts as an injection into the economy, raising income and employment. Stimulating private investment can be achieved by reducing taxation on profits, lowering interest rates, and encouraging technological advancement, which raises MEC and investment incentives.