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Investment Demand Curve

Having discussed the derivation of the MEC curve, we shall now proceed from the MEC curve to the investment demand curve.

Investment will be pushed up to where the marginal efficiency of capital (MEC) will be equal to the rate of interest (r). It follows that given the MEC schedule, the level of investment demand is determined by the rate of interest. Thus, by substituting the marginal efficiency of capital by the rate of interest we get investment demand schedule.

If at $ 2 billion investment, the marginal efficiency of capital is 6%, it can be inferred that at an interest rate of 6% $2 billion of investment will be forthcoming.

Fig. shows the investment demand curve relating investment to alternative levels of interest. In this figure, we measure I and r along the vertical axis and the investment decreases to $ 1.5 billion (I₁) because only this level of investment equates the MEC to i₀. Similarly, when the rate of interest increase to 8% (i₁), investment decreases to $ 1.5 billion (I₁); since only at this level of investment the MEC = i. at 10% rate of interest (i₂ = r₂), investment decrease to $1 billion or so on. This means that the MEC curve itself is the investment demand curve. Since the MEC is downward sloping the investment demand curve will also be downward sloping. It shows that there is an inverse relationship between the rate of interest and investment.