Contents

**Introduction**

One of the key components of aggregate demand in the Keynesian model of macroeconomics is planned investment. Planned investment refers to the amount of spending that firms intend to do on new capital goods, such as machinery, equipment, buildings, and inventories. Planned investment is important for economic growth, as it adds to the productive capacity of the economy and creates employment opportunities.

However, planned investment is not always equal to actual investment, as there may be unplanned changes in inventories due to discrepancies between actual and expected sales. Therefore, planned investment is influenced by various factors that affect the expectations and profitability of firms, such as business confidence, technological innovation, tax policy, and interest rates.

In this article, we will focus on how interest rates affect planned investment in the Keynesian model. We will explain why planned investment is inversely related to interest rates, and how this relationship affects the equilibrium level of income and output in the economy.

**The Marginal Efficiency of Capital and the Interest Rate**

According to the Keynesian theory of investment, firms decide how much to invest by comparing the marginal efficiency of capital (MEC) with the interest rate. The MEC is the rate of return that a firm expects to earn from investing in an additional unit of capital. The interest rate is the cost of borrowing funds to finance the investment, or the opportunity cost of using internal funds instead of lending them out.

The MEC depends on the expected future cash flows from the investment project, which are influenced by factors such as the demand for the product, the price level, the cost of production, and the depreciation rate of the capital. The MEC also depends on the supply price of capital goods, which is the amount that a firm has to pay to acquire a unit of capital.

The MEC curve shows the relationship between the MEC and the amount of investment. It is downward sloping, as more investment implies a lower MEC due to diminishing marginal returns and increasing supply prices. The interest rate is represented by a horizontal line in the diagram below.

The optimal level of planned investment for a firm is determined by the point where the MEC curve intersects with the interest rate line. At this point, the expected return from investing in an additional unit of capital is equal to the cost of financing it. If the MEC is higher than the interest rate, then investing in more capital will increase profits. If the MEC is lower than the interest rate, then investing in more capital will reduce profits.

Therefore, planned investment is inversely related to interest rate in the Keynesian model. A higher interest rate means a higher cost of borrowing or a higher opportunity cost of using internal funds, which reduces the profitability and attractiveness of investment projects. A lower interest rate means a lower cost of borrowing or a lower opportunity cost of using internal funds, which increases the profitability and attractiveness of investment projects.

**The Investment Function and Aggregate Demand**

The inverse relationship between planned investment and interest rate can be expressed by an investment function that shows how much firms plan to invest at different levels of interest rate. The investment function is downward sloping, as a higher interest rate reduces planned investment and a lower interest rate increases planned investment.

The investment function can be added to other components of aggregate demand, such as consumption, government spending, and net exports, to obtain an aggregate demand function that shows how much output is demanded at different levels of income. The aggregate demand function is upward sloping, as a higher income increases consumption and net exports through the multiplier effect.

The equilibrium level of income and output in the economy is determined by the point where aggregate demand equals aggregate supply. Aggregate supply represents the potential output that can be produced with a given level of resources and technology. In the short run, aggregate supply can be assumed to be fixed or horizontal at full employment level.

The diagram below illustrates how changes in interest rate affect equilibrium income and output in the Keynesian model.

![Equilibrium Income and Output]

In panel (a), we see that at an initial interest rate i0, planned investment is I0 and aggregate demand is AD0. The equilibrium income and output is Y0, where AD0 equals aggregate supply AS. In panel (b), we see that a decrease in interest rate to i1 increases planned investment to I1 and shifts aggregate demand up to AD1. The new equilibrium income and output is Y1, where AD1 equals AS. In panel ©, we see that an increase in interest rate to i2 decreases planned investment to I2 and shifts aggregate demand down to AD2. The new equilibrium income and output is Y2, where AD2 equals AS.

Therefore, we can see that a lower interest rate stimulates planned investment and aggregate demand, which leads to a higher equilibrium income and output in the economy. A higher interest rate reduces planned investment and aggregate demand, which leads to a lower equilibrium income and output in the economy.

**Conclusion**

In this article, we have explained how interest rates affect planned investment in the Keynesian model of macroeconomics. We have shown that planned investment is inversely related to interest rates, as a higher interest rate reduces the expected return and profitability of investment projects, while a lower interest rate increases them. We have also shown that changes in interest rate affect the equilibrium level of income and output in the economy, as they shift aggregate demand up or down through the investment function. We have illustrated these effects with diagrams and examples.

We hope that this article has helped you understand the role of interest rates in the Keynesian model and how they influence the level of economic activity and growth. Thank you for reading. 😊