Describe about the concept of multiplier and accelator.

Subject Economics
NU Year Set: 3.(c) Marks: 4 Year: 2012

In economics, a multiplier refers to an economic factor that, when increased or changed, causes increases or changes in many other related economic variables. In terms of gross domestic product, the multiplier effect causes gains in total output to be greater than the change in spending that caused it. The term is usually used in reference to the relationship between government    spending and total national income.

Multiplier = change in GDP / change in injections

The key determinants of the value of the multiplier are:

  • The size of the savings ratio - the more people save of any increase in income, the less the increase in spending at each stage of the process.
  • The amount spent on imports - if a lot of the extra spending created goes on imported goods and services, then this money will be lost out of the country and not passed on within the economy.
  • The level of taxation - any increase in income will also mean higher tax revenue. However, if the government use this extra revenue to spend on public sector investment and employment, then this may help the process continue.

Accelerator

We have already looked at how economies tend to grow in cycles - we called this the trade cycle or business cycle. One of the major factors contributing to this cycle is the instability of investment. When the economy is doing well, firms will invest to provide the extra capacity they need for increased production. However, when growth starts to slip, firms will tend to stop investing - in fact investment may become negative. Why invest if there is no need for extra capacity and you cannot even sell what you are currently making! The changes in investment during the different phases of the trade cycle may therefore be several times that of the rise or fall in income.

So we can see that investment depends not so much on the level of income and consumer demand, but on their rate of change. Firms are investing to provide production capacity and so they will invest according to how much demand is growing, not according to the actual level of demand. This link between investment and the rate of change of demand is called the accelerator theory. Fluctuations in investment will be much greater than those in income, but because investment is an injection into the circular flow of income they will have a multiplied effect and this will magnify the ups and downs of the trade cycle.

The accelerator principle states that changes in the level of current income, leading to changes in output of consumer goods, will lead to proportionately greater, or accelerated changes, in the output of capital goods, i.e. investment.

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