key term - Accelerator theory

Definition

Accelerator theory explains how investment levels in an economy are influenced by changes in economic output. Essentially, it suggests that when demand for goods and services increases, businesses respond by increasing their investment in capital goods to meet that demand, creating a cycle of economic growth. This theory emphasizes the link between consumption, production, and investment, making it a crucial concept in understanding the determinants of investment.

5 Must Know Facts For Your Next Test

1. The accelerator theory posits that the rate of investment is proportional to the rate of change in output, meaning that faster economic growth leads to more investment.
2. It highlights that businesses will invest in new capital only when they anticipate an increase in future sales, which can be driven by consumer demand.
3. Investment is often volatile under the accelerator theory because small changes in demand can lead to significant changes in investment levels.
4. This theory can help explain why economies experience cycles of booms and busts, as investment responds quickly to changing output levels.
5. In a recession, the negative impact on demand can lead to reduced investment, further deepening economic downturns due to the feedback loop.

Review Questions

• How does the accelerator theory connect changes in economic output with business investment decisions?
  • The accelerator theory connects changes in economic output with business investment decisions by suggesting that increases in output lead businesses to invest more heavily in capital goods. When demand rises, firms expect higher future sales and thus increase their investments to expand production capacity. This creates a reinforcing cycle where higher output encourages further investment, which can stimulate additional economic growth.
• Evaluate the implications of accelerator theory for understanding business cycles and investment behavior during different economic phases.
  • The implications of accelerator theory for understanding business cycles are significant, as it explains why investment tends to rise during economic expansions and fall during recessions. When the economy is booming, the increasing demand leads businesses to invest heavily in new capital to capture market opportunities. Conversely, during downturns, reduced consumer demand results in less investment, which can further exacerbate economic contractions. Understanding these dynamics helps economists predict fluctuations in investment behavior across different phases of the business cycle.
• Critically analyze how external factors such as interest rates or government policy might influence the accelerator effect on investment.
  • External factors like interest rates and government policy critically influence the accelerator effect on investment. Lower interest rates can reduce the cost of borrowing, making it easier for businesses to finance new investments and thus amplifying the accelerator effect as companies respond to rising demand. Conversely, restrictive monetary policies or high-interest rates can dampen investment despite positive changes in output because they increase financing costs. Additionally, government policies such as tax incentives for capital investment or public spending can significantly alter business expectations about future sales, either enhancing or reducing the accelerator's impact on overall investment levels.

Related terms

Marginal Efficiency of Capital:

The expected rate of return on an additional unit of capital, influencing firms' decisions to invest.

Investment Demand Curve: A graphical representation showing the relationship between interest rates and the level of investment demand in the economy.

Business Cycle: The fluctuations in economic activity over time, typically characterized by periods of expansion and contraction.