Accelerator Theory

What is Accelerator Theory?

The accelerator theory, a Keynesian concept, stipulates that capital investment outlay is a function of output. For example, an increase in national income, as measured by the gross domestic product (GDP), would see a proportional increase in capital investment spending.

Understanding Accelerator Theory

The accelerator theory is an economic postulation whereby investment expenditure increases when either demand or income increases. The theory also suggests that when there is excess demand, companies can either decrease demand by raising prices or increase investment to meet the level of demand. The accelerator theory posits that companies typically choose to increase production, thereby increasing profits, to meet their fixed capital to output ratio.

Fixed capital to output ratio states that if one (1) machine was needed to produce a hundred (100) units and demand rose to two hundred (200) units, then investment in another machine would be needed to meet this increase in demand. From a macro-policy point of view, the accelerator effect could act as a catalyst for the multiplier effect, though there is no direct correlation between these two.

The accelerator theory was conceived by Thomas Nixon Carver and Albert Aftalion, among others, before Keynesian economics, but it came into public knowledge as the Keynesian theory began to dominate the field of economics in the 20th century. Some critics argue against the accelerator theory because it removes all possibility of demand control through price controls. Empirical research, however, supports the theory.

This theory is typically interpreted to establish new economic policy. For example, the accelerator theory might be used to determine if introducing tax cuts to generate more disposable income for consumers — consumers who would then demand more products — would be preferable to tax cuts for businesses, which could use the additional capital for expansion and growth. Each government and its economists formulate an interpretation of the theory, as well as questions that the theory can help answer.

Accelerator Theory Example

If there is a clear indication that this higher level of demand will be sustained for a long period, a company in an industry will likely opt to boost expenditures on capital goods — such as equipment, technology, and/or factories — to further increase its production capacity. Thus, demand for capital goods is driven by heightened demand for products being supplied by the company. This triggers the accelerator effect, which states that when there is a change in demand for consumer goods (an increase, in this case), there will be a higher percentage change in demand for capital goods.

An example of a positive accelerator effect is investment in wind turbines. Volatile oil and gas prices increase the demand for renewable energy. To meet this demand, investment in renewable energy sources and wind turbines increases. However, the dynamic can occur in reverse. If oil prices collapse, wind farm projects may be postponed, as renewable energy is economically less viable.