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 repre-
sented 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 one-fifth 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:

PeriodOutput(income)RequiredCapital Net Gross

Stock of ReplacementInvestmentInvestment
Capital
(1) (2) (3) (4) (5) (6)
t- 1 500 1,500 300 0 300
t 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 0 345
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 0
t + 9 400 1,200 240 0 240
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.