The Role of Expectations and Investment in an MTP

Keynes Chapters 5, 11, 12, and 18

Part I- The Role of Expectations and their Developments

a. Two Different Types of Expectations:

i. Short Term Expectations: the price a manufacturer can
expect to get for his finished output at the time when he
commits himself to starting the process required to produce
it; the current supply price of goods
ii. Long Term Expectations: what the entrepreneur can hope
to earn in the shape of future returns if he purchases
‘finished output’ as an addition to his capital equipment
iii. The first is considered as a production process decisions
(although it involves investment expenditures) while the
latter is more of a traditional investment decisions since he
is adding to his capital stock.
iv. Each individual firm in deciding daily output determined
by ST Expectations which will be impacted by LR
Expectations of other parties and therefore it is on these
various expectations that employment decisions will be
made and offered.
v. The actual results of events will only matter insofar as to
help shape the expectations that go into forming future
expectations. Moreover, the results of decisions made on a
certain set of expectations will work themselves out over
time so that (1) a certain time period will elapse in which
events are dictated by past events and (2) during that time
period decisions are made by one individual that will affect
the decisions of other individuals in another period so that
each enterprise’s balance sheets are intertwined as one’s
financing decisions will be affected by other companies.
b. Long Term Expectations:
i. Ergodic vs. Non-ergodic
ii. Ergodic: refers to a process in which each sequence of a
sample size is equally representative of the whole; similar
to drawing a sample with replacement. This means that
there is a probability that an event will occur with
probability X. If it occurs, then the object is replaced and it
is as likely to occur again as in the past with probability X.
However, if it is not replaced, then the probability that it
will occur again is different since one observation is no
longer present. This will then affect the future probability
distributions once that observation is picked and so on and
so forth. This is known as Cumulative Causation in which
one event affects future ones in a non-predictable way.
 iii. Non-ergodic: similar to non-replacement except that there
is no probability distribution that can be formed about the
likelihood of events. The world is simply unknown. This
is uncertainty.
iv. Fundamental Uncertainty: When it is impossible to form a
definite probability distribution of how likely events are.
Say that you are trying to predict the likelihood that a war
will break out between Egypt and Brazil in 2050. What is
the probability distribution for this? It is impossible to
calculate because the future course of Cumulative
Causation is unknown. Certain backroom deals may be
made, certain allies may attack each other, and certain
natural disasters may occur that are simply unknown and
cannot be predicted. Thus, there is fundamental uncertainty
when attempting to predict the future course of action when
making an investment decision that has ramifications over a
twenty to thirty year period, such as building a new
production factory in Egypt.
v. Since because it is impossible to know anything for sure,
yet investment decisions have to be made in order to secure
profits, what is the process by which these decisions are
made?
c. Role of Conventions and Animal Spirits:
i. When making an investment decision, the entrepreneur
attempts to reasonably make a prediction as to the course of
future events. In addition, they attempt to frame the market
in such a way so as to ensure that the investment decision
will be successful. In order to do so, entrepreneurs form
conventions and rules of thumb on which they can rely
since fundamental uncertainty exists. In other words, since
they know that they do not know anything for sure, they
build a model of the system for themselves so that they can
make decisions when something occurs.
ii. Role of Animal Spirits: Once they feel enough information
has been accumulated that pertains to the decision,
entrepreneurs get their ‘animal spirits’ which is a
suspension of their uncertainty that they know they do not
know and then make an investment based upon the
information they have accumulated.
iii. Contagion, Herd Behavior: Since there is uncertainty, and
individuals know that they do not know the future, if one
group makes a strong investment move in the market then
there may be ramifications that cause herd behavior from
other individuals. For example, if one person sees a few
powerful people pulling out of a certain market, s/he may
do the same simply because that original person knows that
 they do not know the future and therefore maybe the other
individuals are better informed/have some information that
the first person does not. Accordingly, they do not wish to
make a loss and so they will pull out of the market as well.
The result is large movements in investments and therefore
huge swings can occur. This is what makes investment so
volatile and unpredictable.

Part II- The Marginal Efficiency of Capital- Keynes’ Theory of Investment

a. When an entrepreneur purchases a capital asset, they do so with expectations as to

the amount of ‘quasi-rents’ or the prospective yields of the various assets and the
monetary flows that it will provide them with. Call this series of payments over
time Q1, Q2,…Qt.
b. Against this we have the supply prices of these capital assets which are not the
market prices of this output (what such assets are currently being sold for) but are
the price that is needed to induce a manufacturer to newly produce another unit of
that asset. This is sometimes thought of as the replacement cost.
c. The relationship between these two factors is what contributes to the pace of
investment. Specifically, the rate of discount that would equate the prospective
yields with the supply prices will be called the marginal efficiencies of capital
assets and one rate can be identified for each specific capital asset. In other
words, it would be (Q1/R1) + (Q2/R2) + …+ (Qt/Rt) = Supply Price. The largest
number of each of these various marginal efficiencies of capital assets will be
known as the marginal efficiency of capital. Note that it is the expected yields
and current supply prices; the past yields of an investment here are irrelevant.
d. Now take the capital asset with the highest marginal efficiency of capital. As
investment in this particular type of capital asset increases, two price effects will
occur to affect the marginal efficiency of capital for that asset.
i. First, the prospective yield will decline as that asset
becomes less and less scarce. That is, as that capital
asset becomes more abundant, the yield will
become less and less.
ii. Secondly, the current supply price will increase as
increased pressure is put on the facilities
responsible for producing that asset; that is, as the
demand for it increases, its current supply price will
increase because there are only so many locations
that it can be produced at.
iii. The combined effect serves to lower the marginal
efficiency of capital for that asset as investment in
increases and the asset becomes more abundant.
iv. Hence, for each individual capital asset we can
construct a schedule which shows by how much
investment in it would have to increase so that its
marginal efficiency would fall to a given level.
e. We can then aggregate these schedules to identify how aggregate investment will
relate to/affect the marginal efficiency of capital in general at that pace of
investment.
f. Investment will be undertaken until the point at which the marginal efficiency of
capital will be equal to the rate of interest. Once that point has passed, then
investment will cease to occur since the point in an MTP is to make money or, at
a minimum, to not lose it in an investment with a lower yield than can be
procured from holding onto it. What determines the interest rate is yet to be
determined.
i. Hence, the interest rate is determined by another set
of factors and these must be determined if we are to
figure out how to manipulate the rate of investment
to ensure that D2 fills the gap between output and
D1.
ii. This means that the interest rate is not determined
by the demand for investment and the supply of
investment funds as in the loanable funds market.