Induced Investment and the Accelerator

The proportion of Gross National Product (GNP) that enters into investment goes a long way to determine the economic growth of a country. Autonomous investment is determined by rate of interest and marginal efficiency of capital. It does not change with the change in national income. However, the other type of investment, namely Induced Investment, varies with the national income. With every increase in National Income, induced investment keeps on increasing. It is called 'Induced' because a change in National Income induces a change in investment.

Example: National Income changes from $1,000 billion to $2,000 billion, and induced investment changes from $200 billion to $400 billion

Change in National Income = ΔY = $1,000 billion

Change in induced investment = ΔI = $200 billion

Then, Marginal Propensity to Invest (i) = ΔI/ΔY = 200/1000 = 1/5

Change in Induced Investment divided by change in National Income gives us the Marginal Propensity to invest, denoted by 'i'.

Example:
The accelerator shows the accelerated effect on investment due to a small change in output or sales. 'v' is the accelerator or capital/output ratio. It shows the amount of capital required to produce one unit of output.

When output increases by 25 units, from 75 to 100, and the value of 'v' is 2, capital stock must increase by 50 units. This increase in capital stock is nothing but investment.

Thus, induced investment depends on the rate of change of GNP and the accelerator. If sales or output fails to increase period after period, no new investment will be undertaken. Therefore, for net investment to be positive, it is essential that output must not only be high; it should be changing. This is the Acceleration Principle.

The Accelerator illustrated
Net investment = change in capital (requirement) stock

We assume that there is a constant rate of depreciation of $10 per unit. Gross investment is net investment + depreciation.
A small change in output will lead to an accelerated change in investment. When output increases by 20%, gross investment increases by 200%. For every 1% increase in output, there is a 10% increase in gross investment.

When output fails to increase in the 6th year, gross investment drops down by 75%.

If output starts falling, net investment will be negative, and the firm will start selling some of its capital equipments. Gross investment will take place to the extent of depreciation only.

The accelerator is a very powerful factor and it works with the multiplier in causing cyclical fluctuations in business activities.