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…. .