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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. Theories on Investment spending.
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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 arebased 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…
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 • 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
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!
