Accelerator Effect: Meaning, How It Works

An accelerator effect is an effect in the economy where small changes in the gross domestic product (GDP) result in changes in more substantial aggregate investment spending. That is the reason why we often see a surge in capital spending when the economy grows strong.

The accelerator principle helps explain the business cycle. It explains why, when the economy expands, the economy grows higher and higher. But, if the economy contracts, it could lead to a recession.

How the accelerator effect works

The accelerator effect links changes in national income to changes in capital investment of the business sector. We use GDP as a representation of national income. By definition, GDP measures not only aggregate output but also measures aggregate expenditure and income in the economy.

Initially, as the economy grows or recovers, aggregate demand increases. Companies respond by using existing capacity more intensively. Or, they can also deplete the stock of finished products in warehouses.

If demand then grows more robust, the business will raise capital expenditure to increase production capacity. It will spend money on new machines, factories, and technology. They also recruit more workers to operate new machines.

Capital investment also needs to rejuvenate its old fixed assets. That way, the benefits of fixed assets last longer. So, investment needs not only come to increase capacity but also to replace worn machines.

Thus, when businesses expect demand to remain high, they feel the need to spend more capital. As a result, the business capital stock will be higher.

Let’s take a simple example.

A company operates 4 production machines with an output capacity of 50 per year. So, at full capacity, the company serves 200 units of purchase.

Say, demand increased to 210. With the existing capacity, the company was unable to meet demand. Hence, it buys a new machine (assuming the same capacity of 50 units per year). So, capital stock increases by 25% = [(5/4) – 1] x 100%, while demand increases by 5% = ((210/200) -1] x 100%.

Consider, one machine is outdated and only produces for the next two years. Anticipating demand will continue to grow, the company buys a new machine to replace it. 

So, the company’s capital investment buys not only one machine but also two machines (capital stock increases by 50%).

What factors influence the accelerator effect?

Let’s draw some conclusions from the simple example above to find the answer. 

Business expectations for future demand. If more optimistic that demand will grow stronger, companies are more confident of increasing capital expenditure. More significant capital expenditure will then also encourage higher economic growth as output increases.

New capital investment requires employees to operate machinery. Businesses will recruit new employees to do it. As a result, the unemployment rate falls, and the household’s income prospect is more positive, driving higher demand. Greater demand drives further increases in capital expenditure and aggregate output.

Remember. The opposite effect also applies when demand slows during economic contraction. Slowing demand may lead to further contractions, an early sign of recession.

Changes in consumer income and expenditure levels. The initial increase in demand affects the amount of capital investment by the business.

Say, in the above case, the demand increases to 260 units (up 30%). Because the capacity of new machines is 50 units per year, the business needs to add two new machines. By operating 6 machines, the company’s production increases to 300. 

And, if the company buys just one new machine, the production is only 250, insufficient to meet demand.

The useful life of fixed assets. If more obsolete machines operate, the need for capital investment will be even higher.

Once again, in the example above, the old machine still has a long operating life. The company feels no need to replace it and only enough to buy one new machine. Therefore, the company only bought one machine, instead of two machines to replace the old one.

Level of capacity utilization. If the machine operates at full capacity, the need to invest in capital goods becomes higher.

In contrast, if some machines are idle, the company can still use its existing capacity to increase output and meet demand.

Say, a company operates 80% of the full capacity of its machines. At the utilization rate, the company produces an output of 80 units.

Assume, market demand increases from 70 to 90 units. Instead of buying a new machine, the company can increase its utilization to 90%.

The availability of investment funds and the cost of capital to buy fixed assets. If the company has a lot of money, buying capital goods is less problematic. Likewise, when machine prices are low, it means low investment costs, encouraging companies to purchase new machines as current capacity is insufficient.

Government incentives such as taxes or subsidies. Higher taxes increase operating costs, it reduces incentives to invest in capital goods.

Production subsidies work in reverse. Providing subsidies reduces production costs, which encourages companies to invest.

Main drawbacks

Increasing production capacity requires a time lag. Building a new factory does not take two or three months. That requires more time. Hence, when demand rises, it does not immediately encourage companies to invest.

Companies are more careful about making decisions. If they decide to invest, demand may stagnate when a new plant has been completed. So, the investment is a bad business decision. It only increases market supply, pushes prices down, and reduces profitability.

The accelerator effect also ignores the possibility of outsourcing to other businesses. Instead of buying new machines or building new factories, companies can outsource to meet small increases in short-term demand.