Question

Explain the volatility of investments using the discussion on the accelerator effect?

Answer 1

The accelerator effect states that investment levels are related the rate of change of GDP. Thus an increase in the rate of economic growth will cause a correspondingly larger increase in the level of investment. But, a fall in the rate of economic growth will cause a fall in investment levels.

Why the accelerator effect occurs

• If firms see a rise in demand and expect this demand to be maintained, then they will soon start to reach full capacity.
• Therefore, to meet the future demand, they will respond by investing now. To meet a growth in demand may require considerable investment outlay.
• Because of economies of scale in investment, it is more efficient to make a significant investment (e.g. increase capacity 20%) – rather than small annual increases in investment of 2%.
• Therefore, firms will wait for promising economic conditions, before embarking on investment decisions.

Implications of the accelerator effect

• Investment tends to be more volatile than economic growth
• The rate of economic growth stays the same. Investment levels will also stay the same
• 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, investment spending can fall very significantly.
• Accelerator Coefficient. This is the level of induced investment as a proportion of a rise in National income accelerator coefficient = Investment/change in income.