2.

Accelerator Theory of Investment According to the accelerator theory of investment, is not the rate of profit but the rate of increase in output that creates pressure to acquire capital goods. In other words, it is the rate of increase in output that determines investment. Thus, rate of investment depends on the changes in the level of output. Assumptions: The capital output ratio remains constant. There is no excess capacity in the economy. There is elastic credit facility in the economy. There are other unemployed resources in the economy to combine with capital to produce more output. Supply price of capital is constant. Let us denote the capital output ratio by w' which denotes the desired capital to produce one unit of output. Symbolically, w=Kt/Yt Or, Kt = w. Yt(i) Equation (i) shows that capital stock of an economy is a certain part of the output. Lagging one period, Kt-1 = w.Yt-1(ii) Subtracting equation (ii) from equation (i), Kt-Kt-1=w(Yt-Yt-1) Or, It = w(Yt-Yt-1);..(iii) Equation (iii) shows that net investment depends on the changes in the level of output. If Yt >Yt-1, there is positive net investment. If Yt < Yt-1, there is negative net investment. Equation (iii) can be written in the form of gross investment also. It+ Dt = w(Yt-Yt-1) +Dt Igt=w(Yt-Yt-1)+Dt(iv) This equation shows that gross investment also depends on the rate of changes in the level of output. Illustration Assumptions: w=2 Dt =10% of the initial capital stock.
Period Output(Yt) Yt-Yt-1 Desired capital stock (Kt=wYt) Actual Capital stock Dt It Igt=It+Dt

3 4

210 220

10 10

420 440

420 440

20 20

20 20

40 40

1 2

200 200

0 0

400 400

400 400

20 20

0 0

20 20

5 250 30 500 500 20 60 80 6 270 20 540 540 20 40 60 7 260 -10 520 520 20 -20 0 8 256 -4 512 512 20 -8 12 9 250 -6 500 500 20 -12 8 10 230 -20 460 480 20 0 11 200 -30 400 460 20 0 12 190 -10 380 440 20 0 13 210 20 420 420 20 0 14 220 10 440 440 20 20 40 Column 2 shows output. Column 3 shows the rate of change in output. Column 4 shows desired capital stock which is two times the output given w=2. Depreciation is 5% of the initial capital stock i.e. 5% of 400=20. We see that in from period 1 to 2, there is no change in output and no change in investment. However, even in this case, replacement capital of 20 units is made as such the gross investment equals 20. In period 3, output increases by 10 units. So, investment increases by 20 as such It=20 and Igt=40. Period 3 to 4, output increases by 10 and I t = 20. We see that if change in output is constant, Igt can be constant. In period 5, output rises by 30, Igt rises by 80. In period 5 to 6, output rises by 20, Igt declines to 60. This shows that gross investment actually declines if output increases at a decreasing absolute amount. In period, output falls by 10. It = -20 and Igt=0. Output further declines in period 8 but Igt increases. It is because output now falls at a slower rate. From period 8 onwards, output falls at a greater speed from 6 to 20 to 30. However, for the economy as a whole, capital stock cannot fall by more than depreciation (20 units). So, actual capital actually falls by maximum 20 units. Period 10 to 12 is the period of excess capacity. The acceleration principle fails here. Excess capacity is removed at period 13 as actual and desired capital stocks are equal. Now onwards, the acceleration principle again works. In this way, the accelerator theory argues that investment depends on the rate of change in the absolute level of output in the economy.