The accelerator effect posits that an increase in GDP growth will cause a proportionally larger increase in investment spending. For example, a 3% increase in GDP growth will result in investment rising by more than 3%. Conversely, a fall in GDP growth will lead to a more than proportional fall in investment.

The underlying idea behind the accelerator effect is the relationship between GDP growth and investment. As GDP growth increases, income and consumption increases, more goods must be produced, more capital is needed to produce these additional goods and, therefore investment increases.

#### Accelerator Formula

A simple accelerator model is:

K = f(•Y)

Where K is the capital stock, •Y is GDP growth and f is a positive function greater than 1.

Assume f = 2. If •Y is £20 billion then investment in the capital stock must rise by £40 billion (20 x 2).

#### Implications of the Accelerator Effect

• The accelerator effect suggests that investment is more volatile than economic growth. This matches empirical observations.
• The level of investment will remain the same if the rate of economic growth doesn’ change.
• Investment spending may fall even if total GDP rises. For instance, using our previous example of f = 2, if GDP grows by £20 billion then investment will increase by £40 billion. If GDP then grows by £10 billion in the next year then investment will only rise by £20 billion. So as GDP growth slows down, investment spending will slow down.

#### The Accelerator Effect & the Business Cycle

The accelerator effect can help explain business cycles. If national output is growing at an increasing rate then net investment will also grow, but if the rate of output growth slows then net investment will fall. The accelerator effect will then interact with the multiplier effect to cause fluctuations in the trade cycle.

For example, as GDP growth slows, investment spending will fall (the accelerator effect), less machines will be produced, less workers will be needed to produce machines, incomes will fall, consumption falls, AD falls and GDP growth falls again (multiplier effect).

#### Criticisms of the Accelerator Effect

Investment is affected by many factors other than the rate of change of GDP, and these factors may mitigate or even prevent the accelerator effect. For instance, investment is influenced by:

• Interest rates. A rise in interest rates may curb investment spending even if GDP growth is rising.
• Animal spirits. If investor confidence is high then investment spending could rise even if GDP growth is falling.
• Technological improvements. If technology advances and new capital goods produce even more consumption goods than before then less investment will be needed in the future.
• Time lags. When firms decide to invest in the capital stock the results are not instantaneous. For example, firms may decide to invest next year or may even wait for a long period of time to see if the rise in GDP growth requires them to invest in more machinery to produce more consumer goods.