Rising Investment

The “Accelerator.” Rising consumer spending means rising sales for businesses. This will deplete inventories and push firms toward capacity limits in factories and stores. Thus, rising sales sooner or later will stimulate more investment. This effect of more consumption spending in inducing more investment we call the “accelerator,” or the “acceleration effect.” it provides the link to complete the cumulative interaction in the upswing: more investment —~ more income —~ more consumption —* more investment, and so on. in summary, the upswing is a cumulative multiplieraccelerator process.

Unless the original burst of investment and its multiplied effect on consumption in turn induce more investment, there will be no cumulative upswing—only a hump on the floor of the depression. But if the rise in consumer spending does produce a substantial accelerator effect, then the revival is on. The further induced investment in turn produces its multiplier effect, which in its turn may induce further investment. How big and how repetitive the acceleration effect is, are crucial questions in determining whether the revival grows or withers. If both the multiplier and the accelerator are large, any revival that gets started will be an explosive one, with consumption and investment interacting vigorously. If either is zero, that’s the end of the upswing.

How strong will the accelerator in fact be? The answer is, different at different times. Rising incomes and sales will induce new investment whenever they make the desired amount of plant and equipment larger than the actual amount on hand. Thus, if sales rise and the producer has no excess productive capacity, his desired stock of plant and equipment will clearly exceed his present stock, since without more capacity he can’t meet the expanding demand. But if he begins with excess capacity, he has more plant and equipment than he currently needs, so even increased sales won’t necessarily raise his desired stock above what he has.

Pragmatically, when the economy is just emerging from a serious recession, the outlook for a larger accelerator effect from rising sales is bad, for two reasons:

1. Idle capacity is widespead during depression, and moderate increases in demand can often be met by using existing idle equipment.

2. Businessmen, whatever the capacity situation is, may cautiously wait to see whether the increased demand is permanent. If they do, no acceleration effect will ocur. Their desired stock of capital depends on the permanence they attach to the increased demand.

But if revival progresses and idle capacity vanishes, further increases in consumer spending are more and more likely to stimulate new investment. History and theory both suggest that the acceleration effect can be powerful.

In some cases, an increase in consumer demand may stimulate a much more than proportional increase in investment spending on plant and equipment, providing a large accelerator. Suppose, for example, that the shoe industry produces = 100 million pairs of shoes per year; that it has 1,000 shoe machines, each producing 100,000 pairs per year; and that the average life of shoe machines is 10 years. This means that 100 machines wear out and have to be replaced each year.

Now suppose that consumer demand rises by 10 per cent next year, to 110 million pairs. To meet this demand, if they have no excess capacity or extra inventories, shoe manufacturers will have not only to replace the regular 100 machines wearing out but also to buy 100 new machines to produce the additional 10 million pairs demanded. In this case, a 10 percent increase in final product demand leads to a 100 per cent increase in the demand for plant and equipment.

But the acceleration effect is not a stable booster for the upswing. Suppose consumer demand stays at 110 million in the third year. Now manufacturers will have the productive capacity needed to meet this demand if they replace only the regular 100 worn-out machines. (None of the extra new machines need replacement yet, of course.) Thus, the demand for new machines drops back to the original level of 100 per year, a drop of 50 per cent, even though consumer demand stays unchanged at the new higher level.

Worse, assume that in the fourth year consumer demand for shoes drops below the original level, to 90 million pairs annually. Then manufacturers don’t have to buy any new shoe machines at all. They don’t even have to replace the ones that wear out that year. The demand for new machines drops to zero as a result of a relatively small drop in the demand for shoes.

This shoe illustration, though purely hypothetical, does indicate how modest shifts in consumer demand can, through the acceleration effect, give rise to sharp spurts of induced investment or to correspondingly steep slumps, even though neither is likely to be permanent.The accelerator is likely to be especially large for durable goods. For example, if houses ordinarily last 50 years, each year about 1/50 of all houses may be replaced (say, 1 million houses annually). Assume that as the result of higher incomes in a recovery, 1 million young couples who had been living with relatives decide they want new homes. This increase of %o, or 2 per cent, in the total stock of homes demanded will result in a 100 per cent increase in the demand for new homes. Here again, note that the induced new investment in houses is a temporary lump that will vanish the next year unless there is a further increase in the number of young people setting up their own houses.

The acceleration effect can account for a big part of the observed changes in investment as consumption rises. But not for all of them. Some other determinants of the cyclical behavior of investment may be at least as important.