Post on 22-Feb-2016
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THE ACCELERATOR THEORY
ACCELERATOR THEORY
Whereas the multiplier attempted to explain the consequences of a change in investment, the accelerator theory focuses on the causes of a change in
investment spending
THEO RIES O N IN VESTMENT SPENDING
Up to now, we have assumed that business decisions about investment spending are based solely on interest
rates. The Accelerator theory provides a different explanation….
THE ACCELERATOR THEORY
The Accelerator theory argues that firms make investment decisions based on changes in output (real GDP). This attempts to explain the unpredictable nature of the “animal spirits”
ANIMAL SPIRITS
Keynes argued that changes in investment were the most important cause of
fluctuations in the business cycle. The accelerator theory tries to explain why
investment spending is constantly changing
A R EFRESHER ON INVESTM EN T SPENDING
Hopefully, this formula looks like a long lost friend….
Gross investment = Depreciation +
Net Investment
INVESTMENT SPENDING
Total investment spending consists of the sum of spending on
capital goods that have depreciated and spending on new capital goods
ASSUMPTIONS OF THE THEORY
The Accelerator theory assumes that firms try to have a fixed proportion of capital goods to output. So when output increases, firms will need more capital goods…
AN EXAMPLE…
Let’s assume a firm produces 1,000 units of a product with 10 machines that produce 100 units each. Every year 1 machine needs to be replaced….Let’s look at some data…
HERE’S THE DATAYear Output Change
in output
Machines needed
Depreciation
NetInvestm
ent
Gross Investm
ent1 1000 102 1000 0 10 1 0 13 1100 100 11 1 1 24 1200 100 12 1 1 25 1200 0 12 1 0 16 1100 -100 11 0 0 0
OBSERVATIONS
Based on our example, we see that with a 10% increase in production
in year 3, investment spending doubled from 1 machine to 2
MORE OBSERVATIONS
In year 4, output continued to rise, but investment spending
leveled off, as investment spending remained constant at 2 machines
ADDITIONAL OBSERVATIONS
In year 5, as production leveled off at 1200 units, investment
spending fell from 2 to 1 machine….and by Year 6, as
output fell to 1100 units, investment spending dropped to 0
CONCLUSIONS
Changes in investment depend on changes in output (GDP)
Small changes to output (GDP) can lead to large changes in investment
When output (GDP) begins to rise, investment booms
If output (GDP) remains constant, investment falls
If output (GDP) falls, investment spending drops to 0
THE ACCEL ERATOR IN THE R EAL WO RL D
Critics argue that the wild swings portended by the Accelerator theory may not hold, depending
on unemployment, and level of utilization of capital goods. If there is spare capacity in the
economy and underutilized capital goods, investment may not occur even if GDP increases
THE ACCEL ERATOR AN D THE MULTIPL IER
These two may be linked to create great increases or decreases in GDP. Increases in investment (I) contribute to the multiplier effect, which can lead to more investment and more GDP growth…….and the converse as well…
CROWDING OUT
CROWDING OUT
The crowding-out effect involves a reduction in investment spending due to
higher interest rates which have risen due to expansionary fiscal policy decisions
made by the federal government
STEP 1—GOVERNMENT ENACTS EXPANSIONARY FISCAL POLICY
STEP 2—DEMAND FO R M ON EY INCREAS ES
STEP 3—INVESTMENT SPENDING FALLS AS
INTEREST RATES RISE
BEST LAID PLANS
Higher interest rates lead to decreased AD from the private sector, somewhat (or perhaps completely) nullifying the expansionary policy that the government pursued in the beginning of this process….
THE CROWDING OUT CONTROVERSY
As usual, economists disagree about when it occurs and to what extent. Keynesians believe the effect will be small, especially
during recession, while neoclassicists warn that crowding out is always a grave danger!
CAN’T THES E TW O EVER AGR EE? I GUESS NO T…. .