The Accelerator Effect, a Keynesian concept, is used to explain the level of investment in an economy. The accelerator effect refers to a positive effect on private fixed investment of the growth of the market economy. Investment is a function of changes in National Income, especially consumption. Investment is a key component of aggregate demand.
When income and therefore consumption of the people increases, more goods will have to be produced. This expansion will require more capital to produce them if the existing stock of capital has been entirely used. If this is the case, then the investment is induced by changes in income or consumption to increase capacity. This is known as induced investment.
If National Income is constant, investment will be consistent.
- National Income ↑ = Investment ↑
- National Income ↓ = Investment ↓
The assumption behind the Accelerator Effect is that firms will want to main a fixed capital to output ratio, meaning that if a factory uses 1 machine to produce 1000 goods, and the firms needs to produce 3000 goods more, then the firm will buy 3 more machines.
Factors ‘Dampening’ the Accelerator Effect
Firms can use existing stock to make up for a temporary rise in demand.
2. Capacity of Existing Machines
Firms can use the existing machinery more or for longer to increase capacity.
3. Business Confidence
If the firms’ forecasted demand is true, they wouldn’t need to invest in more machines.
4. Price of Machinery
Prices of machines could go up with an increase in demand, which could reduce investment in the machines.
5. Capacity of Other Factors of Production
Even if machinery is there, skilled workers or other factors of production might not be available to make up the needed capacity.
6. Economic Life of Existing Machines
Machines might last longer than expected, therefore reducing the need for investment.
7. Contract Out
Firms can give out orders to other firms instead of buying new machines.
Implications of the Accelerator Effect
Investment tends to be more volatile than economic growth. If the rate of economic growth stays the same, then the investment level will also stay the same.
2. Gross Domestic Product
Investment spending can fall even when GDP is rising. This is because if there is a fall in the rate of economic growth firms may invest less. If GDP falls then investment can fall significantly.