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So long as the value of yields or returns exceeds the expected replacement cost (V > Cr) investment activity becomes profitable. More and more assets will then be demanded. But with every additional or marginal asset purchased the value of V will go on falling. The capital assets will be demanded and investment will be made upto the point of equality between the two (V = Cr). When the two values are just equal, the two rates of discount will also be equal (r = i). The equality between the two sums and the two rates of discount is an equilibrium condition since there is no further inducement to invest. Equilibrium rate of discount on return (r) is the MEC of Keynes. Hence it is that rate of discount which brings about equality between the two series. MEC value depends upon the general rate of the economy therefore it is a function of the level of income 'Y'. But lower market rate of interest (i) is also favorable in maintaining a relatively higher value of MEC. Therefore MEC is a function of these two variables. It is a downward sloping function,
MEC = f (y, i)
in the sense that lower the rate of interest, more attractive will be the investment activity. It is necessary therefore to reveal the forces which determine rate of interest.
ii) Speculative motive: In determination of the rate of interest Keynes has introduced speculative motive which creates demand for hoarding money or liquidity. Therefore his interest rate theory is known as liquidity preference (LP) theory. Under the LP theory, rate of interest is a pure monetary phenomenon. Before Keynes the rate of interest was explained as a real phenomenon. The classical theories are based on abstinence or the waiting involved in the act of saving. In other words, the activity of saving causes some sacrifice or inconvenience and rate of interest is the price paid to compensate for this.
But Keynes has regarded savings as a negative activity which does not require any compensation. Yet rate of interest is positive because it helps to dissuade speculators from hoarding liquid assets. This difference in the classical and Keynesian approaches arises because of their distinct approach to demand for money or liquidity. The classical economists assume that Transactions motive and Precautionary motive are the only two motives to be satisfied by the demand for money. But Keynes observed that in the modern economy there is a class of speculators who hoard large quantities of liquid resources. The demand for money made by speculators is meant for investing in securities when market conditions are favorable and to withdraw the demand by selling securities when it is profitable. Therefore the Speculative motive creates demand for liquidity with an intention of making capital gains out of fluctuating market conditions for securities. Speculative demand for money is Keynes’ novel concept and it has caused a fundamental change in the traditional monetary theory.
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