Chapter XI is the first in a series of chapters on the subject of investment, and this section is the longest in the General Theory. Hopefully Keynes will wrap up some of his loose ends and present his theory in an understandable fashion.
Section I: Keynes begins Chapter XI by attempting to define the marginal efficiency of capital as, "being equal to that rate of discount which would make the present value of the series of annuities given by the returns expected from the capital-asset during its life just equal to its supply price." He then continues with a simple deduction from the principle of supply and demand that when investment increases in a certain type of capital the marginal efficiency will decrease. This will continue until the marginal efficiency of capital is equal to the market rate of interest.
This seems like a fairly trivial concept, but allow me to delve deeper. We can think of the supply price as what a firm would buy the capital goods for, and the expected returns as what it receives for selling either the finished good to the consumers or a higher order capital good to another firm. Thus, the marginal efficiency of capital is the rate of price spreads in the stages of production. From Austrian economic theory, we know that this is precisely equal to the rate of interest. Thus, Keynes misses a crucial aspect of interest theory - that his marginal efficiency is the rate of interest.
Section II: Keynes continues by outlining three ambiguities surrounding the marginal efficiency of capital. None of these ambiguities are of critical importance to his discussion of the marginal efficiency of capital so I will leave them be. If I missed anything of importance in this section please feel free to comment.
Section III: Keynes notes the distinction between the current yield and the prospective yield of a given capital stock is routinely overlooked, which results in confusion surrounding the marginal efficiency of capital. I have not read enough of the literature that was available at the time to know if this is true, but I agree that using current yield in the place of prospective yield will often result in erroneous conclusions. One of the main purposes of an entrepreneur is to foresee future changes, which are accounted for in the prospective yield.
Keynes continues by noting that changes in the value of money will affect the marginal efficiency of capital. He spends a decent amount of time outlining the different situations that will arise when the change in value of money is foreseen or unforeseen. The important point, which Keynes fails to note, is that changes in the value of money are usually foreseen when money is derived from a commodity - say silver or gold. A fiat money system with a controlling central bank is far more likely to affect the value of money, and coincidental the marginal efficiency of capital. One would think that limiting any unforeseen changes in the value of money would be beneficial for the economy as entrepreneurs would be less likely to make errors in forecasting. Keynes neglects to note this point.
Section IV: Here Keynes describes the risks associated with investment. The first being the risk taken by a man when he invests his money in capital. If he incorrectly forecasts the prospective yield of his investment, he will lose money (unless he assumes he will make less money than what actually transpires, in which case he would earn a profit). The second being the risk taken by person A when he lends money to person B or firm C to invest as the individual or firm seems fit. Keynes claims that because both the lender and the borrower are incurring a risk in this case, it is added twice to the pure rate of interest, making investments more costly. I believe Keynes is misguided in that he assumes the borrowing and investment to be one transaction.
For example, if I borrow a friend $100 for a year and charge 5% interest, I expect to receive $105 a year from now. If my friend in turn takes the $100 to buy a lawnmower to start a lawn mowing service, that is a separate transaction. The risk he incurs by investing in the capital to start his business is separate from the risk I take borrowing money to my friend. Thus, the duplication of the risk is not true as two transactions are taking place.
Keynes claims that this doubling of risk is important for understanding trade cycle (business cycle) theory so we will have to wait until he reaches that point in his analysis to see how this so called doubling of risk affects his views of the business cycle.
Section V: Keynes concludes this chapter by arguing that the marginal efficiency of capital is of significant importance because it accounts for future changes, as we have seen through its reliance on prospective yields. He then makes an egregious error by claiming the rate of interest is, "virtually, a current phenomenon." I am not entirely sure on what reasoning he bases this claim, but considering the rate of interest in determined on the time market it must be based on both present and future considerations. Thus, Keynes ends this chapter in a similar manner to how it began, by making crucial mistakes regarding the connection between the marginal efficiency of capital and the interest rate.