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
THEORIES ON
INVESTMENT 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 REFRESHER ON
INVESTMENT 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 DATA
Year
Output
Change in
output
1
1000
2
1000
0
3
1100
4
Machines
needed
Depreciation
Net
Investment
Gross
Investment
10
1
0
1
100
11
1
1
2
1200
100
12
1
1
2
5
1200
0
12
1
0
1
6
1100
-100
11
0
0
0
10
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 ACCELERATOR IN THE
REAL WORLD
 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 ACCELERATOR AND
THE MULTIPLIER
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 FOR
MONEY INCREASES
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 THESE TWO EVER
AGREE? I GUESS NOT…..