Transcript Accelerator

Explaining the business cycle:
the instability of investment
and the accelerator
Keynesians believe fluctuations in
output are due to fluctuations in AD.
One reason for these fluctuations is
due to the instability of investment…
Instability of Investment: the accelerator
• One of the major factors contributing to the ups
and downs of the business cycle is the instability of
investment.
• When an economy begins to recover from a
recession, investment can rise very rapidly. When
the growth of the economy slows down, however,
investment can fall dramatically, and during a
recession can all but disappear.
• Since investment is an injection into the circular
flow of income, these changes in investment wil
cause multiplied changes in income an thus heighten
a boom or deepen a recession.
The Accelerator Model
The relationship between a rise
in national income and the
effect upon investment by firms
• Demand for capital is derived from the
demand for the goods and services it
produces
• An increase in demand, which is
expected to persist and cannot be met
with existing capacity leads firms to
undertake new investment- known as
induced investment
• The accelerator theory suggests that the
level of induced investment will be
determined by the rate of change of NI
(and not interest rate).
• When NI is rising rapidly, then firms will
want to meet increasing demand by
expanding their capacity.
• But as the rate of GNP growth falls,
businesses will no longer need to add to
capacity and so investment levels fall back
to the original level necessary to maintain
depreciated capital.
Explanation
• Firms must invest to replace depreciated
equipment.
• Assume firms are currently spending at a
constant rate in order to maintain the level of
existing capital.
• A rise in Y causes C to increase which is an
increase in demand for goods and services.
• If the firms want to meet the rising demand,
they have to increase the level of their
investment to increase their capacity.
• This type of investment is called induced
investment
Example
• Firm A makes toasters. It has annual
demand of 200,000 toasters and operates
20 machines to meet this demand.
• Capital output ratio is 10:1 (capital output ratio
is the amount that has to be spent on capital to produce
$1 worth of national output)
• Each machine costs $20,000 and each year
1/10 of its machines is replaced due to
depreciation (2 machines p.a)
• Total investment p.a. will be $40,000
• NI rises causing C to increase and
demand for toasters to increase by 5%
• Demand is now 210, 000.
• If Firm A wants to meet this demand,
total investment will be $60,000
($40,000 to replace the depreciated
machines plus induced investment of 1
machine ($20,000) to meet the
additional demand).
• There is a 50% increase from regular
investment.
Therefore…
• A small increase in demand (5%) can
lead to a large increase in investment
(50%)
• Investment accelerates when demand
rises.
• As GNP growth falls, firms no longer
need to add to spare capacity so
investment will fall back to original level.
Handout
• Has there been an accelerator effect
over the past thirty years?
• How do we link the multiplier and the accelerator?
• Induced investment is subject to the multiplier effect,
increasing national income further, as NI rises this sets of an
accelerator effect increasing induced investment….
• Eg. A rise in G will lead to a multiplied rise in NI.
• This rise will set off the accelerator effect: firms will respond
to the rise in NI and resulting rise in consumer demand by
investing more.
• This rise in I will then be subject to the multiplier.
• If this rise in income is bigger than the first, there will be a
second rise in investment (the accelerator), which will in turn
cause a third rise in income (the multiplier) and so on….
• The larger the value of the multiplier (the bigger the marginal
propensity to consume) the greater the accelerator effect upon
the economy.
• This is known as the combined multiplier/ accelerator effect and
can explain the upward momentum in the recovery phase of the
business cycle.
• Also works in reverse…
Questions
Next topic: Investment &
Crowding Out
Then the Laffer Curve
Can do after unemployment