Accelerator effect

Definition

The accelerator effect refers to the phenomenon where an increase in consumer demand leads to a more than proportional increase in investment by firms. This effect emphasizes how changes in demand can influence production levels and, consequently, spur further economic activity by prompting businesses to invest in more capital to meet that demand.

5 Must Know Facts For Your Next Test

1. The accelerator effect implies that during periods of economic growth, firms will tend to increase their investments at a higher rate than the increase in consumer demand.
2. This concept highlights the cyclical nature of economies, where rising demand can lead to capital expansions, which in turn further enhance production capacity and stimulate even more demand.
3. It also suggests that economies can experience boom-bust cycles; a decline in demand can lead to reduced investment and potential recession.
4. In Post-Keynesian economics, the accelerator effect is critical for understanding how fluctuations in demand can lead to significant changes in employment and economic output.
5. The strength of the accelerator effect can be influenced by factors such as business confidence, access to credit, and the overall economic environment.

Review Questions

• How does the accelerator effect illustrate the relationship between consumer demand and business investment?
  • The accelerator effect shows that when consumer demand increases, businesses respond not just by meeting this demand but by ramping up their investments significantly more than the rise in demand itself. This reaction is due to firms needing to expand their production capacities to prepare for sustained higher levels of demand. Consequently, this investment creates new jobs and stimulates further economic growth, establishing a feedback loop between demand and investment.
• In what ways does the accelerator effect contribute to understanding economic cycles, particularly during times of expansion and contraction?
  • The accelerator effect helps explain why economies experience cycles of expansion and contraction. During expansions, increased consumer demand leads to heightened investment from businesses aiming to capitalize on growth opportunities. Conversely, during downturns, falling demand results in decreased investment, which can exacerbate economic decline. This cyclical behavior highlights the importance of maintaining stable consumer confidence to prevent severe fluctuations in economic performance.
• Evaluate how the accelerator effect interacts with other economic theories, such as Keynesian economics and the multiplier effect, to shape overall economic policy.
  • The accelerator effect complements Keynesian economics by illustrating how increased consumer spending can drive investment beyond mere maintenance of production levels. Additionally, it interacts with the multiplier effect, as both concepts emphasize how initial increases in spending lead to broader economic stimulation. Policymakers often consider these relationships when designing fiscal policies aimed at boosting aggregate demand and encouraging business investments, especially during economic downturns. Understanding these interactions helps craft effective strategies for promoting sustainable economic growth.

Related terms

Keynesian economics: A school of thought that emphasizes the role of aggregate demand in influencing economic output and employment levels, suggesting that increased spending can help stimulate growth.

multiplier effect: An economic concept that describes how an initial increase in spending can lead to a larger overall increase in economic activity, as the initial funds circulate through the economy.

investment function: A relationship that shows how investment levels by businesses are influenced by factors such as interest rates, expected returns, and current demand.