1. 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…

2. 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.

3. The Accelerator Model The relationship between a rise in national income and the effect upon investment by firms

4. 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

5. 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.

6. 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

7. 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

8. 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.

9. 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.

10. Handout Has there been an accelerator effect over the past thirty years?

11. 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…

12. Questions

13. Next topic: Investment & Crowding Out Then the Laffer Curve Can do after unemployment