Relationship between Investment and Rate of Interest

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Hi friends, in today’s article we are going to know about the relationship between Investment and Rate of Interest. So let’s discuss in details. The volume of private investment depends on the two factors –

(i) Marginal Efficiency of Capital (MEC)

(ii) The rate of interest.

What is the relationship between investment and interest rate?

The relationship between investment and the rate of interest is shown in the following figure –

Relationship between Investment and Rate of InterestIn the above figure, along the Y axis, both rate of interest and marginal efficiency of capital (MEC) are shown. On the other hand, X axis is shown capital stock.

We have already explained that equilibrium level of investment is established at point where marginal efficiency of capital equals the rate of interest. In the figure, when rate of interest is Or1 then the optimum capital stock is OK1.

If rate of interest falls from Or1 to Or2 MEC will be greater than rate of interest. It will raise demand for capital to OK1 because corresponding to this capital stock MEC becomes equal to the new rate of interest aerate from Or1 to Or2, K1K2 amount of rate of net investment will be made.

Similarly, when rate of interest further falls from Or2 to Or3, equilibrium level of capital stock will be K3 which is achieved if K1K2 amount of net investment is undertaken.

It can be shown that the curve MEC acts as investment demand schedule corresponding to various rates of interest. The shifts in the MEC also affect investment demand which in the following figure –

Relationship between Investment and Rate of InterestIn the above diagram, if MEC1 curve shifts from MEC1 to MEC3 then investment decrease from I2 to I1. Similarly, if MEC shifts upward then investment will be increase.


So friends, this was the concept of the relationship between Investment and Rate of Interest. Hope you get the full details about it and hope you like this article.

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