The Accelerator Model

The accelerator model suggests a positive relationship between investment and the rate of
growth of demand or output. Accelerator theories assume that for a business there is a desired
capital stock for a given level of output and interest rates. A rise in output or a fall in interest
rates may prompt increased levels of investment as firms adjust to reach the new optimal
capital stock level.

Inflation Rate of
Interest (%)

SRAS

R%

AD3

AD2

AD1 ID ID2

Y1 Y2 Y3 I1 I2

Real National Income Planned investment spending

The accelerator model works on the basis of a fixed capital to output ratio. For example if
demand in a given year rises by £4 million and each extra £1 of output requires an average
of £3 of capital inputs to produce this output, then the net level of investment required will be
£12 million. Consider the diagram above that shows an outward shift of the AD curve that
then causes an expansion of short run production higher profits and prompts an increase in
planned investment at each rate of interest. This boost in demand and output is said to bring
about a positive ‘accelerator effect.’
One criticism of this simple accelerator model is that the capital stock of a business can rarely
be adjusted immediately to its desired level because of ‘adjustment costs’ and ‘time lags’.
The adjustment costs include the cost of lost business due to installation of new equipment or
the financial cost of re-training workers. Firms will usually make progress towards achieving an
optimum capital stock rather than moving smoothly from one optimal size of plant and
machinery to another. The time lags might be caused by supply-bottlenecks in industries that
manufacture buildings and items of capital equipment.
A further criticism of the basic accelerator model is that it ignores the spare capacity that a
business might have at their disposal. For example in the latter stages of a recession, most
businesses are operating well below their capacity limits. If demand then picks up in the
recovery phase of the cycle, they can make more intensive use of existing capacity. Investment
spending is likely to pick up strongly towards the latter stages of a cycle – the risk being that
fresh supply becomes available just at the time when demand is tailing off.
Percentage of industrial firms working below capacity
CBI Industrial Trends Survey, quarterly data
80 80

75 75

70 70
Per cent of firms below capacity

65 65

60 60

55 55

50 50

45 45

40 40

35 35

30 30
86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

Source: CBI Manufacturing Survey

Capacity utilisation and investment

The chart above shows the percentage of industrial firms operating below full capacity. The
data series is cyclical; notice how low the figure was during the boom of the late 1980s. In
contrast, by the summer of 2009 over three-quarters of industrial sector businesses were
reported as working below their capacity. As the scale of spare capacity increases, we expect
to see a fall in planned investment and this is exactly what has happened.
From container ships to hotels and from steel plants to airlines, the fall in demand has lowered
capacity utilisation and put a big squeeze on profits. That pressure on profit margins comes
not just from weaker revenues. Keep in mind that many businesses have a large fixed cost
component such as the overhead costs of operating a network. Thus when output is contracting,
the average fixed costs of production increase
Business profitability
Business profits play an important role in allocating resources – for example, higher profits
provide the funds for capital investment and also for research and development projects.
Profits tend to follow a cyclical pattern – they fall during a recession or an economic slowdown.
And they recover during phases of stronger economic growth
 Business Profits and the Economic Cycle
Real GDP Growth (Top) and Net rate of return on capital employed (Bottom)
5 5
4 4
3 3

% change in GDP
2 2
1 1
0 0
-1 -1
-2 -2
-3 -3
-4 -4
-5 -5

18 18
Rate of return (%) (millions)

16 16

14 Service Sector Industries 14

millions
12 12

10 10
Manufacturing
8 8

6 6
99 00 01 02 03 04 05 06 07 08

Source: CBI Manufacturing Survey

Services
Manufacturing
Manufacturing industry has suffered a profits squeeze in recent years and profitability is volatile because
of big shifts in commodity prices and exchange rates
Key reasons for the fall in UK investment during the recession
1. Sharply weakening demand – the result of a slump in domestic and external demand
2. Rising levels of spare capacity – falling demand means less capacity is being fully
used
3. Worsening cash flows – many businesses are struggling to generate cash as demand
tails away
4. Tight credit conditions – lines of funding for investment have frozen or become more
expensive
5. Deteriorating profitability – the recession has cut profit margins
6. Concerns about the potential length and depth of the recession – weak animal spirits
Suggestions for further reading on investment
Nissan announces big rise in investment in the North East (BBC news, July 2009)
Severn tidal power plan moves ahead (Guardian, January 2008)
Tories urge cut in Corporation Tax (BBC news, March 2008)
Building BRICs of growth (The Economist, June 2008)
Does North Sea Oil have a future? (BBC news, June 2008)
Major new rail lines considered (BBC news, June 2008)
UK businesses cut back investment (BBC news, December 2008)
UK tops inward investment target league (BBC news, June 2009)
£28m investment at Airbus factory (BBC news, June 2009)
BA to cut capital spending by 20% (BBC news, July 2009)