In an economy, firms will invest based on the change in demand rather than what demand actually is. The relationship between income and demand is the accelerator theory. The accelerator theory states that the changes in income and in the output of consumer goods will lead to proportionately greater output of capital goods. Like the multiplier effect, we are looking at the effects of injections, specifically investment, on aggregate demand except more specifically, we are looking at how income has an accelerated effect on investment which stimulates the explains the instability in the trade cycle. There are some qualifications for the accelerator to take place:
- The industry has to be producing at full employment
- Increased demand for capital goods will only increase if the increase in demand is believed to be permanent.
- There could be a rise in the prices of capital goods and therefore can be a fall in demand and more savings instead. Then the accelerator would be reduced.
The accelerator assumes that the relationship between change in consumption and the change in investment is fixed but there are exceptions. There is a time lag between a change in consumption and the implementation of investment decisions.
