DEFINITION OF 'ACCELERATOR THEORY'

An economic theory that suggests that as demand or income increases in an

economy, so does the investment made by firms. Furthermore, accelerator
theory suggests that when demand levels result in an excess in demand,
firms have two choices of how to meet demand.

Raise prices to cause demand to drop.

Increase investment to match demand.
The accelerator theory proposes that most companies choose to increase
production thus increase their profits. The theory further explains how this
growth attracts more investors, which accelerates growth.

INVESTOPEDIA EXPLAINS 'ACCELERATOR THEORY'

The accelerator theory was developed early in the twentieth century by
Thomas Nixon Carver and Albert Aftalion, among others. Although this theory
was conceived before Keynesian economics, it emerged just as the Keynesian
theory came to dominate the economic mindset of the twentieth century.
Critics argue that accelerator theory should not be used because it eliminates
the possibility of controlling demand through price controls. However,
empirical research on the accelerator theory has supported its use.

The accelerator theory is interpreted to create economic policies. For

example, would it be better to use tax cuts to create more disposable income
for consumers who would then demand more products, or would it be faster
to give those cuts to business, which will then be able to use more capital for
growth? Every government and their economists create their own
interpretation of accelerator theory and the questions it can be used to
answer

The Accelerator Theory of Investment (with its Criticism)!

The Keynesian concept of multiplier which states that as the investment

increase, income increases by a multiple amount. On the other hand, there is
a concept of accelerator which was not taken into account by Keynes has
become popular after Keynes, especially in the discussions of theories of
trade cycles and economic growth. The acceleration principle describes the

effect quite opposite to that of multiplier. According to this, when income or

consumption increases, investment will increase by a multiple amount.

When income and therefore consumption of the people increases, the greater
amount of the commodities will have to be produced. This will require more
capital to produce them if the already given stock of capital is fully used.
Since in this case, investment is induced by changes in income or
consumption, this is known as induced investment.

The accelerator is the numerical value of the relation between the increase in
investment resulting from an increase in income. The net induced investment
will be positive if national income increases and induced investment may fall
to zero if the national income or output remains constant.

To produce a given amount of output, it requires a certain amount of capital.

If Yt output is required to be produced and v is capital-output ratio, the
required amount of capital to produce Yt output will be given by the following
equation:

Kt = vYt

Where,

Kt stands for the stock of capital

Yt for the level of output or income, and

v for capital-output ratio.

This capital-output ratio v is equal to K/Y and in the theory of accelerator this
capital-output ratio is assumed to be constant. Therefore, under the
assumption of constant capital-output ratio, changes in output are made
possible by changes in the stock of capital. Thus, when income is Yt then

required stock of capital Kt = vYt when output or income is equal to then

required stock of capital will be Kt-1 = vYt-1.

It is clear from above that when income increases from Yt-1 in period t-1 to Yt
in period, t, then the stock of capital will increase from Kt-1 to Kt. As seen
above, Kt-1 is equal to vYt-1 and Kt is equal to vYt..

Hence, the increase in the stock of capital in period t is given by the following
equation:

Kt Kt-1 = vYt vYt-1

Since increase in the stock of capital in a year (Kt - K t-1) represents

investment in that year, the above equation (ii) can be written as below:

Equation (iii) reveals that as a result of increase in income in any year t from
a previous year t 1, increase in investment will be v times more than the
increase in income. Hence, it is v i.e., capital-output ratio which represents
the magnitude of the accelerator. If the capital-output ratio is equal to 3, then
as a result of a certain increase in income, investment will increase three
times more i.e., accelerator here will be equal to 3.

It thus follows that investment is a function of change in income. If income or

output increases over time, that is, when Yt is greater than Y t-1 then
investment will be positive. If income declines, that is, Yt is less Y t-1 then
disinvestment will take place. And if the income remains constant, that is, Yt
= Y t-1 the investment will be equal to zero.

An arithmetical example will make clear the working of the accelerator. This
has been represented in the accompanying table.

We have made the following assumptions in making this table:

(i) Capital-output ratio remains constant and is equal to 3.

(ii) The depreciation that takes place in the stock of capital is equal to onefifth of the stock existing in the previous year. Therefore, one-fifth of the stock
of capital is to be replaced every year.

Table 8.1. Explanation of the Accelerator:

Investment:

Period

Output(income)

Required Stock of Capital

Capital Replacement

Net Investment

Gross Investment

(1)

(2)

(3)

(4)

(5)

(6)

t- 1

500

1,500

300

300

510

1,530

300

30

330

t+ 1

525

1,575

306

45

351

t+2

550

1,650

315

75

390

t+3

575

1,725

330

75

405

t+4

575

1,725

345

345

t+5

560

1,680

345

-45

300

t+6

550

1,650

336

-30

306

t+7

500

1,500

330

- 150

180

t+8

400

1,200

300

-300

t+9

400

1,200

240

240

In the table, it is supposed that in period t 1 and several periods before it,
output or income is equal to Rs. 500. Given that the capital-output ratio is
equal to 3, then to produce Rs. 500 worth of output, Rs. 1500 worth of capital
will be required. [K = vY; 1500 = 3(500)] which is written in column (3). Since
depreciation of capital occurred in period t 1, will be one-fifth of the stock of
capital existing in the previous period (which is also Rs. 1500). Therefore,
replacement investment in period t 1 will be equal to Rs. 300. Since as
compared to the previous period, there is no change in output in period t- 1,
the net investment in period t- 1 will be equal to zero. As a result, the gross
investment in period t- 1 will be equal to Rs. 300.

Now suppose that production in the period t rises to Rs. 510 crores as a result
of increase in Government expenditure or autonomous investment. To
produce output worth Rs. 510 crores, total capital worth Rs. 1530 is required
[Kt = vYt 1530 = 3(510)] which is written in column (3). Thus, as a result of
increase in output (income) by Rs. 10, net investment has increased by Rs.
30, that is, 1530 1500 = 30 which means that accelerator is here equal to
3. In period t the depreciation equation equal to 1/5th of the capital stock of
period t- 1 will occur, that is, capital depreciation of Rs. 300, (1/ 5 x 1500 =
300) will occur in period t. Therefore, capital replacement investment in
period t will be equal to Rs. 300.

Thus, gross investment in period t will be equal to 30 + 300 = 330. In this

way, if output (or income) increases by Rs 15 in period t + 1, Rs. 25 in period
t+ 2, and also Rs. 25 in period I + 3, the net investment will increase by three
times the increment in output (or income), that is, net investment will
increase by Rs. 45 in period t + 1, Rs. 75 in period t + 2 and also Rs. 75 in
period t + 3. It will be further observed from Table 8.1 that when output falls
in period t + 5 by Rs. 15, the net, investment will decline by 3 times of it, that
is, equal to Rs. 45. Likewise, from changes in output in different periods we
can find out net investment that will take place in any period and with the
capital replacement investment we can obtain the gross investment that will
occur in any period.

A glance at columns 2, 5 and 6 will show that with a change in output,

investment will increase by a multiple of it. This shows that acceleration
principle is a powerful destabilising force working in the economy. If the

accelerator is the only force at work, then we shall have too much of
instability in the economymore than is actually found. In real life, we find
that there are limits to instability, both in the upward as well as the
downward direction, so that fluctuations in economic activity or what are
called business cycles must have a peak as well as a bottom.
Criticism of the Accelerator Theory:

The principle of acceleration has come in for a good deal of criticism in recent
years. For example, it has been pointed out by Kaldor that we cannot assume
a constant value of the accelerator throughout the trade cycle, that is, it is
not true that an increase in output or income by an amount must always give
rise to a multiple increase in investment. This is because, if already, some
machines are lying idle, we shall try to use them before rushing in for new
equipment.

Also, if expectation of entrepreneurs is that the rise in demand brought about

by increase in income or output is only a temporary one, they will try to meet
it by overworking the existing machinery rather than installing a new plant.

Thus, in the theory of accelerator it has been assumed that there is no excess
capacity existing in consumer goods industries. In other words, it has been
assumed that no machines are lying idle and no extra shift working is
possible. If there had been excess capacity and extra shift working was
possible, the supply of goods could be increased with the existing equipment
and the accelerator would not come into play.

Further, in the principle of acceleration principle it has also been assumed

that in the capital goods industries, there exists surplus productive capacity. If
there is no excess capacity in the machine-making industries, increased
demand for machines caused by the requirement for additional output would
not lead to increase in the supply of machines. In the absence of supply of
machines, investment cannot increase in the short run.

It is thus assumed in the accelerator theory that the machine-making

industry is capable of increasing its output for the time being at least. The
supply can be increased by reducing stocks of finished machines, by working
extra shifts, and so on.

But stocks cannot be reduced below zero and working double shifts or
adoption of other experiments is found to be expensive. Only when the
demand has increased permanently, will the entrepreneurs find it worthwhile
to increase investment in machine-making industries.

The size of the accelerator does not remain constant over time. Its value will
be affected by the businessmens calculation regarding the profitability of
installing new plants to make more machines on the basis of their probable
working life. It is also assumed that the demand for machines will remain
stable in future, although the increase in demand has suddenly cropped up.

However, in spite of the above limitations of acceleration principle, it points

out an important force which causes economic fluctuations in the economy.
Economists like Samuelson, Hicks and Dusenberry have shown how
accelerator combined with multiplier provides an adequate and satisfactory
theory of trade cycles that occur in the capitalist economies.
The Accelerator Effect

The accelerator effect is when an increase in national income results in a

proportionately larger rise in investment

Consider an industry where demand is rising at a strong pace.

Firms will respond to growing demand by expanding production and making

fuller use of their existing productive capacity. They may also choose to meet
higher demand by running down their stocks of finished products.

At some point and if they feel that the higher level of demand will be
sustained they may choose to increase spending on capital goods such as
plant and machinery, factories and new technology in order to increase their
capacity. If this investment goes beyond what is needed simply to replace
worn out, fully depreciated machinery, then the capital stock of the business
will become larger.

In this sense, the demand for capital goods is being driven by the demand for
the products that the firm is supplying to the market. This gives rise to the

accelerator effect - the principle states that a given change in demand for
consumer goods will cause a greater percentage change in demand for
capital goods.

A good example might be the surge in capital investment in wind turbines

due to the super-high level of oil and gas prices and a rising market demand
for renewable energy. In this case, strong demand created a positive
accelerator effect. But this can also go into reverse e.g. during an economic
slowdown or recession. World oil prices have collapsed and many wind farm
projects have been scaled back or postponed.

Similarly the sharp fall in UK motor car production is also leading to a reverse
accelerator effect with planned investment spending subject to severe cutbacks and many jobs lost.

The Capital Output Ratio

The accelerator model works on the basis of a fixed capital to output ratio
For example if demand in a given year rises by 4 million and each extra 1
of output requires an average of 3 of capital inputs to produce this output,
then the net level of investment required will be 12 million.
One criticism of this simple accelerator model is that the capital stock of a
business can rarely be adjusted immediately to its desired level because of
adjustment costs and time lags. The adjustment costs include the cost of
lost business due to installation of new equipment or the financial cost of retraining workers. Firms will usually make progress towards achieving an
optimum capital stock rather than moving smoothly from one optimal size of
plant and machinery to another.

A further criticism of the basic accelerator model is that it ignores the spare
capacity that a business might have at their disposal and also their ability to
outsource production to other businesses to meet a short term rise in
demand.

The accelerator principle is used to help explain business cycles. The

accelerator theory suggests that the level of net investment will be

determined by the rate of change of national income. If national income is

growing at an increasing rate then net investment will also grow, but when
the rate of growth slows net investment will fall. There will then be an
interaction between the multiplier and the accelerator that may cause larger
fluctuations in the trade cycle.

The accelerator effect will tend to be high when

The rate change of consumer income and spending is strongly positive

The amount of spare productive capacity for businesses is low
The available supply of investment funds is high