Q&A: What is the accelerator effect?

What is the accelerator effect?

The accelerator effect describes a principle where how much a business chooses to spend on capital investment will be influenced by how quickly demand is growing for their products.

Consider a business or an industry where demand is rising at a strong pace (for the moment we will ignore that most of the UK economy is experiencing a recession!).

Firms will respond to growing demand by expanding production and making fuller use of their existing productive capacity. They may also choose to meet higher demand by running down their stocks of finished products.

At some point – and if they feel that the higher level of demand will be sustained – they may choose to increase spending on new capital goods such as plant and machinery, factories and new technology in order to increase their capacity. If this investment goes beyond what is needed simply to replace worn out, fully depreciated machinery, then the capital stock of the business will become larger.

In this sense, the demand for capital goods is being driven by the demand for the products that the firm is supplying to the market. This gives rise to the accelerator effect - the principle states that a given change in demand for consumer goods will cause a greater percentage change in demand for capital goods.

Wind of change

A good recent example might be the surge in capital investment in wind turbines due to the super-high level of oil and gas prices and a rising market demand for renewable energy. In this case, strong demand created a positive accelerator effect. But this can also go into reverse e.g. during an economic slowdown or recession. World oil prices have collapsed and many wind farm projects have been scaled back or postponed.

Similarly the sharp fall in motor car production in the UK is also leading to a reverse accelerator effect with planned investment spending subject to severe cut-backs and many jobs lost.

Investment and GDP growth in the UK economy

As our chart below shows, the annual change in investment spending is more volatile than the change in GDP. See how the real level of investment is forecast to drop sharply in 2009 because of the recession (falling demand, plenty of spare capacity and a steep decline in business confidence).

The accelerator principle is used to help explain business cycles. The accelerator theory suggests that the level of net investment will be determined by the rate of change of national income. If national income is growing at an increasing rate then net investment will also grow, but when the rate of growth slows net investment will fall. There will then be an interaction between the multiplier and the accelerator that may cause larger fluctuations in the trade cycle.