B.Sc. in Agricultural Economics (Hons.

) Level-3 Semester- I
Course Title: Macro Economics -II (Theory) Course Code: - AGEC-333
Lecture – 5

Theory of Investment
The following points highlight the top three theories of investment in Macro Economics. The
theories are: 1. The Accelerator Theory of Investment 2. The Internal Funds Theory of
Investment 3. The Neoclassical Theory of Investment.

1. The Accelerator Theory of Investment

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.
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. This theory developed by J.M.
Clarke in1923.
Consider an industry where demand is continuing to rise at a strong and rapid pace. Firms that
are operating in this industry respond to this growth in demand by expanding production and
also by fully utilizing their existing capacity to produce. Some companies also meet an increase
in demand by selling down their existing inventory.
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
Accelerator theory is just opposite of multiplier effect. It states that if national output increase
then how much investment is needed to meet up these demand in the economy. The idea is that
in order to meet that demand the economy will require additional stock of capital. Amount of
capital demand will depend on the capital output ratio.
Assumptions:
1. The productive capacity of the economy is fully utilized (there is no excess capacity in
consumption goods sector)
2. Availability of capital goods
3. Fixed output-capital ratio.
The accelerator theory of investment, in its simplest form, is based upon the nation that a
particular amount of capital stock is necessary to produce a given output. For example, a capital
stock of BDT.300 billion may be required to produce 100 billion of output. This implies a fixed
relationship between the capital stock and output.
Thus, X = Kt /Yt
where x is the ratio of Kt, the economy’s capital stock in time period t, to Yt, its output in lime
period t. The relationship may also be written as
Kt = xYt ……………………………………..………(i)
If X is constant, the same relationship held in the previous period; hence
Kt-1 = xYt-1
By subtracting equation (ii) from equation (i), we obtain
Kt –Kt-1 = xYt.x Yt-1 = x(Yt-Yt-1) …………….………(ii)
Since net investment equals the difference between the capital stock in time period t and the
capital stock in time period t – 1, net investment equals x multiplied by the change in output
from time period t – 1 to time period t.
By definition, net investment equals gross investment minus capital consumption allowances
or depreciation. If It represents gross investment in time period t and Dt represents depreciation
in time period t, net investment in time period t equals It – Dt and
It-Dt = x (Yt – Yt-1) = x ∆Y.
Consequently, net investment equals x, the accelerator coefficient, multiplied by the change in
output. Since x is assumed constant, investment is a function of changes in output. If output
increases, net investment is positive. If output increases more rapidly, new investment increases.
From an economic standpoint, the reasoning is straightforward. According to the theory, a
particular amount of capital is necessary to produce a given level of output. For example,
suppose BDT.300 billion worth of capital is necessary to produce 100 billion worth of output.
This implies that x, the ratio of the economy’s capital stock to its output, equals 3. And we
suppose that the depreciation rate of capital is 20%.
Table 1: Accelerator theory of investment
Periods Output Required capital Depreciation Net Gross
stock investment investment
t-1 400 1200 - - -
t 410 1230 240 30 270
t+1 425 1275 246 45 291
t+2 450 1350 255 75 330
t+3 450 1350 270 0 270
t+4 440 1320 270 -30 240
We start our analysis from t-1 period where output was 400 and required capital stock is 1200
as capital-output ratio is 3. In period t, output is 410 and capital requirement is 1230. In this
period depreciation cost is 240 (as we assume 20%) and net investment is 30 (kt – kt-1).
Therefore, gross investment is 270. Accordingly, in t+1 expected output is 425 and to achieve
this amount of output, we need 1275 capital investment. In this period depreciation cost is 246
and net investment is 45. So, gross investment will be 291…….
The accelerator theory of investment is a very important concept for the macroeconomic policy
makers. This theory postulates that how the investment decisions changes in future with the
change in national demand or income. Economic disciple in the long run largely depends on
accurate forecasting. Therefore, if we can calculate the future demand or income and take
preparation about the capital investment decision accordingly then we can achieve the
economic objectives in the long run.
Criticism
In this crude form, the accelerator theory of investment is open to a number of criticisms.
First, the theory explains net but not gross investment. For many purposes, including the
determination of the level of aggregate demand, gross investment is the relevant concept.
Second, the theory assumes that a discrepancy between the desired and actual capital stocks is
eliminated within a single period. If industries producing capital goods are already operating
at full capacity, it may not be possible to eliminate the discrepancy within a single period. In
fact, even if the industries are operating at less than full capacity it may be more economical to
eliminate the discrepancy gradually.
Third, since the theory assumes no excess capacity, we would not expect it to be valid in
recessions, since they are characterized by excess capacity. Based on the theory, net investment
is positive when output increases. But if excess capacity exists, we would expect little or no
net investment to occur, since net investment is made in order to increase productive capacity.
Fourth, the accelerator theory of investment, or acceleration principle, assumes a fixed ratio
between capital and output. This assumption is occasionally justified, but most firms can
substitute labor for capital, at least within a limited range. As a consequence, firms must take
into consideration other factors, such as the interest rate.
Fifth, even if there is a fixed ratio between capital and output and no excess capacity, firms
will invest in new plant and equipment in response to an increase in aggregate demand only if
demand is expected to remain at the new, higher level. In other words, if managers expect the
increase in demand to be temporary, they may maintain their present levels of output and raise
prices (or let their orders pile up) instead of increasing their productive capacity and output
through investment in new plant and equipment.
Finally, if and when an expansion of productive capacity appears warranted, the expansion
may not be exactly that needed to meet the current increase in demand, but one sufficient to
meet the increase in demand over a number of years in the future.