Chapter 18 of Blink and Dorton’s IB Course Companion for Economics Section 3.4 of Matt McGee’s Economics in Terms of the Good, the Bad and the Economist Section 3 of Constantine Ziogas’ IB Study Guide : Economics
Explain
the multiplier effect of injections on national income Calculate the value of the multiplier Explain the accelerator effect of investment on national income Explain what is meant by “crowding out”
Situation:
The government decides to fill a deflationary gap by increasing its government spending. The effect will be the final increase in aggregate demand that is greater than the amount of government spending.
In
fact, any increase in aggregate demand will result in a proportionately larger increase in national income.
Recall:
circular flow diagram, there are injections and withdrawals from the economy. Taxes, imports and savings are withdrawals and investment, exports and government spending are injections.
Government
spends $100 million on a school building project.
Circular Flow of Income Consumption = C
Goods and services (Output)
Households
Firms
Land. Labor, capital and enterprise (factors of production)
Wages + rent + interest + profit= Income (Y) Finance Sector
Investment = I
Taxes = T
Government
Govt. Spending = G
Imports = M
Overseas Sector
Exports = X
Injections
Withdrawals
Savings = S
$100 M
Income of Labor (builders, plumbers, architects, etc.)
Payment to Capital (steel, cement, etc.) and become income of the owners of these factors of production
Tax Savings Imports Spent on domestic goods
withdrawals Income again..
Assumption: Government
spends $100M in an economy. 20% of all additional income goes to taxes, 10% is saved and 10% is used to buy imports. The remaining income of 60% is spent on domestic goods and services. This 60% is known as the marginal propensity to consume and is usually expressed as a decimal, MPC=. 60. Given this information, what is the total spending of the economy from the initial spending of $100M?
Initial spending by government
100M
2nd round of spending=60% of $100M
60M
3rd round of spending=60% of $60M
36M
4th round of spending=60% of 36M
21.60
And so on…. 20th round of spending
0.01M
Total spending including the initial spending by government
249.99 M
Exercise! Try to complete the table and check that the total spending is correct. The final addition to national income, when all the money has been spent and re-spent amounts to $250M, 2.5 times the original government spending of $100M. Any injection into the circular flow of this economy would contribute 2.5x its amount to national income.
MPC
is the proportion of any increase in income used for domestic consumption. MPC= change in C/change in Y. MPW is the proportion of a change in income which does not return to the system in the form of consumption. Equal to MPS, MPM and MRT MPS= change in savings/change in Y MPM=change in imports/change in Y MRT=change in taxes/change in Y
Rather
than do a table to find the value of the multiplier, there are formulas that can be used.
2
ways: (1) Look at the marginal propensity to consume (mpc) or the marginal propensity to withdraw (=marginal propensity to save (mps)+ marginal rate of taxation (mrt)+ marginal propensity to import (mpm))
Multiplier:
(1) The multiplier:
1___ 1-mpc __ 1__________ = mps+mpm+mrt
Example?
1 mpw
Calculate
the multiplier for an economy where the mpc is 0.75 By how much will national income increase in total if there is an investment of $50,000. Answer: Multiplier is 4. 1/0.25=4 National income increases by $200,000 (4*$50,000)
Any
change in any of the withdrawals from the circular flow will change the multiplier. If taxation rate increases, multiplier falls. If mpm falls, multiplier increases. If mps falls, what happens to the multiplier? What are the two things to keep in mind when government plans to intervene to fill a deflationary gap?
It
must estimate the gap between the equilibrium output and full employment output. It must estimate the value of the multiplier so it can judge the suitable increase in AD that is necessary to inject into the economy in order to fill the gap.
The
higher the withdrawals (taxes, imports and savings), the lower the multiplicative effect of any given increase in government spending. Lower interest rates will lower the MPS, lower income taxes will lower the MRT and barriers to trade will lower the MPM. All will lower the MPW and thus increase the value of the multiplier.
The
accelerator theory suggests that the level of induced investment will be determined by the rate of change of national income (and not interest rate). When national income is rising rapidly, then firms will want to meet increasing demand by expanding their capacity. But as the rate of GNP growth falls, businesses will no longer need to add to capacity and so investment levels fall back to the original level necessary to maintain depreciated capital.
Firms
must replace/do replacement investment to replace depreciated equipment. Let us say that firms are already at full capacity and are spending a constant amount on investment in order to maintain the level of existing capital. (they try to replace depreciated equipment). If national income rises, consumption increases then demand from consumers will rise.
If
the firms want to meet the rising demand, they have to increase the level of their investment to increase their capacity. They will invest in NEW plant and equipment to meet the increase in demand. This type of investment is called investment induced investment. Let’s give an example…
One
firm, A, that makes microwave ovens. It has an annual demand of 200,000 ovens and operates 20 machines to meet this demand. Capital to output ratio is (1:10,000). Each machine costs $20,000 and onetenth of its machines is replaced due to depreciation. Total investment per year will be $40000 (10% of 20 times $20,000)
National
income rises causing consumption to increase and demand for microwave ovens increase by 5%. Demand is now 200000*1.1=210,000. If Firm A wants to meet this demand, total investment will be $60,000 ($40,000 to replace the depreciated machines and an investment induced investment of 1 machine ($20,000) to meet the additional demand). There is a 50% increase from regular investment.
A
small increase in demand (5%) can lead to a large increase in investment (50%), we say that investment accelerates when demand rises. How do we link the multiplier and the accelerator.
The
investment induced investment is subject to the multiplier effect, increasing national income further. This is known as the combined multiplier/ accelerator effect and can explain the upward momentum in the recovery phase of the business cycle.
There
are three ways government can fund increased government spending during a fiscal year: printing money, raising taxes or borrowing from its citizens. The question is will borrowing money from its citizens increase aggregate demand? Argument: Assume that the government borrows money (through bond issuance) in order to finance government spending in line with demand side policies.
The
increase in government borrowing increases the demand for loanable funds which increases interest rates and causes investment spending to fall. Thus, the potential increase in AD is negated (crowded out) by the increase in interest rates and fall in investment. However, for crowding out to happen, there are a number of assumptions. Economy is operating at or above the full employment level of output
Second,
real borrowing has to take place, the government’s increased borrowing from either households or the financial sector cannot be compensated by pumping additional money out into the market. How will these work?
interes t
interest
PL
SRAS
S
D1 D0 Loans
LRAS
AD1 IClassical
AD
Investmen t
Real GDP
IKeynesian
If the economy is at full employment and then government increases government spending by increasing borrowing on the open market. There will be an increase in the demand for loans which will drive the interest rate up. The higher interest rate will lower investment.
Partial
crowding out versus complete crowding out. Keynesian: Investment is largely unaffected by interest rates. Classical: Complete crowding out will occur as long as there is real borrowing that is taking place since demand for investment is highly responsive to changes in interest rates.
Explain
the multiplier effect of injections on national income Calculate the value of the multiplier Explain the accelerator effect of investment on national income Explain what is meant by “crowding out”
Situation:
The government decides to fill a deflationary gap by increasing its government spending. The effect will be the final increase in aggregate demand that is greater than the amount of government spending.
In
fact, any increase in aggregate demand will result in a proportionately larger increase in national income.
Recall:
circular flow diagram, there are injections and withdrawals from the economy. Taxes, imports and savings are withdrawals and investment, exports and government spending are injections.
Government
spends $100 million on a school building project.
Circular Flow of Income Consumption = C
Goods and services (Output)
Households
Firms
Land. Labor, capital and enterprise (factors of production)
Wages + rent + interest + profit= Income (Y) Finance Sector
Investment = I
Taxes = T
Government
Govt. Spending = G
Imports = M
Overseas Sector
Exports = X
Injections
Withdrawals
Savings = S
$100 M
Income of Labor (builders, plumbers, architects, etc.)
Payment to Capital (steel, cement, etc.) and become income of the owners of these factors of production
Tax Savings Imports Spent on domestic goods
withdrawals Income again..
Assumption: Government
spends $100M in an economy. 20% of all additional income goes to taxes, 10% is saved and 10% is used to buy imports. The remaining income of 60% is spent on domestic goods and services. This 60% is known as the marginal propensity to consume and is usually expressed as a decimal, MPC=. 60. Given this information, what is the total spending of the economy from the initial spending of $100M?
Initial spending by government
100M
2nd round of spending=60% of $100M
60M
3rd round of spending=60% of $60M
36M
4th round of spending=60% of 36M
21.60
And so on…. 20th round of spending
0.01M
Total spending including the initial spending by government
249.99 M
Exercise! Try to complete the table and check that the total spending is correct. The final addition to national income, when all the money has been spent and re-spent amounts to $250M, 2.5 times the original government spending of $100M. Any injection into the circular flow of this economy would contribute 2.5x its amount to national income.
MPC
is the proportion of any increase in income used for domestic consumption. MPC= change in C/change in Y. MPW is the proportion of a change in income which does not return to the system in the form of consumption. Equal to MPS, MPM and MRT MPS= change in savings/change in Y MPM=change in imports/change in Y MRT=change in taxes/change in Y
Rather
than do a table to find the value of the multiplier, there are formulas that can be used.
2
ways: (1) Look at the marginal propensity to consume (mpc) or the marginal propensity to withdraw (=marginal propensity to save (mps)+ marginal rate of taxation (mrt)+ marginal propensity to import (mpm))
Multiplier:
(1) The multiplier:
1___ 1-mpc __ 1__________ = mps+mpm+mrt
Example?
1 mpw
Calculate
the multiplier for an economy where the mpc is 0.75 By how much will national income increase in total if there is an investment of $50,000. Answer: Multiplier is 4. 1/0.25=4 National income increases by $200,000 (4*$50,000)
Any
change in any of the withdrawals from the circular flow will change the multiplier. If taxation rate increases, multiplier falls. If mpm falls, multiplier increases. If mps falls, what happens to the multiplier? What are the two things to keep in mind when government plans to intervene to fill a deflationary gap?
It
must estimate the gap between the equilibrium output and full employment output. It must estimate the value of the multiplier so it can judge the suitable increase in AD that is necessary to inject into the economy in order to fill the gap.
The
higher the withdrawals (taxes, imports and savings), the lower the multiplicative effect of any given increase in government spending. Lower interest rates will lower the MPS, lower income taxes will lower the MRT and barriers to trade will lower the MPM. All will lower the MPW and thus increase the value of the multiplier.
The
accelerator theory suggests that the level of induced investment will be determined by the rate of change of national income (and not interest rate). When national income is rising rapidly, then firms will want to meet increasing demand by expanding their capacity. But as the rate of GNP growth falls, businesses will no longer need to add to capacity and so investment levels fall back to the original level necessary to maintain depreciated capital.
Firms
must replace/do replacement investment to replace depreciated equipment. Let us say that firms are already at full capacity and are spending a constant amount on investment in order to maintain the level of existing capital. (they try to replace depreciated equipment). If national income rises, consumption increases then demand from consumers will rise.
If
the firms want to meet the rising demand, they have to increase the level of their investment to increase their capacity. They will invest in NEW plant and equipment to meet the increase in demand. This type of investment is called investment induced investment. Let’s give an example…
One
firm, A, that makes microwave ovens. It has an annual demand of 200,000 ovens and operates 20 machines to meet this demand. Capital to output ratio is (1:10,000). Each machine costs $20,000 and onetenth of its machines is replaced due to depreciation. Total investment per year will be $40000 (10% of 20 times $20,000)
National
income rises causing consumption to increase and demand for microwave ovens increase by 5%. Demand is now 200000*1.1=210,000. If Firm A wants to meet this demand, total investment will be $60,000 ($40,000 to replace the depreciated machines and an investment induced investment of 1 machine ($20,000) to meet the additional demand). There is a 50% increase from regular investment.
A
small increase in demand (5%) can lead to a large increase in investment (50%), we say that investment accelerates when demand rises. How do we link the multiplier and the accelerator.
The
investment induced investment is subject to the multiplier effect, increasing national income further. This is known as the combined multiplier/ accelerator effect and can explain the upward momentum in the recovery phase of the business cycle.
There
are three ways government can fund increased government spending during a fiscal year: printing money, raising taxes or borrowing from its citizens. The question is will borrowing money from its citizens increase aggregate demand? Argument: Assume that the government borrows money (through bond issuance) in order to finance government spending in line with demand side policies.
The
increase in government borrowing increases the demand for loanable funds which increases interest rates and causes investment spending to fall. Thus, the potential increase in AD is negated (crowded out) by the increase in interest rates and fall in investment. However, for crowding out to happen, there are a number of assumptions. Economy is operating at or above the full employment level of output
Second,
real borrowing has to take place, the government’s increased borrowing from either households or the financial sector cannot be compensated by pumping additional money out into the market. How will these work?
interes t
interest
PL
SRAS
S
D1 D0 Loans
LRAS
AD1 IClassical
AD
Investmen t
Real GDP
IKeynesian
If the economy is at full employment and then government increases government spending by increasing borrowing on the open market. There will be an increase in the demand for loans which will drive the interest rate up. The higher interest rate will lower investment.
Partial
crowding out versus complete crowding out. Keynesian: Investment is largely unaffected by interest rates. Classical: Complete crowding out will occur as long as there is real borrowing that is taking place since demand for investment is highly responsive to changes in interest rates.
- Theory Of Investment Value Pdf
- Download The Accelerator Theory Of Investment Pdf Download
- Download The Accelerator Theory Of Investment Pdf Pdf
- Theory Of Investment Value
- The Accelerator Theory Of Macroeconomics
Essays in the Theory of Economic Growth - download pdf or read online. Posted By: admin. By Joan Robinson (auth.). Investment decisions are then not affected by chance changes in current receipts (there is no 'accelerator') and accumulation continues smoothly on its path until some basic change in conditions or some major chance event.
Let us make in-depth study of the accelerator theory of investment in an economy.
Explanation to the Theory:
The Keynesian concept of multiplier states that as the investment increases, income increases by a multiple amount.
The accelerator theory of investment posits that investment spending is largely determined by firms’ cash-flows, so an increase in output growth raises revenues and profits and encourages or allows extra investment to take place. Download citation. The q theory of investment stresses the important role of expectations to investment under uncertainty that are ignored by the accelerator theory and the Jorgenson. Application of the multiplier theory for analysis of investment processes on the municipal level Application of the multiplier-accelerator theory enables us to identify trends of development of socio-economic systems on any levels. The start of a business cycle in the spiral of investment processes is accompanied by the multiplier effect. Si111ple accelerator theory As noted in Chapter 2, net investment is the flow into the stock of capital; it augments the capital stock. Simple accelerator theory describes the process of capital stock adjustment as follows: businesses accumulate capital, i.e. Undertake net investment, when they want a larger capital stock and they.
On the other hand, there is a concept of accelerator which was not taken into account by Keynes which has become popular after Keynes, especially in the discussions of theories of trade cycles and economic growth.
ADVERTISEMENTS:
The acceleration principle describes the effect quite opposite to that of multiplier. According to this, when income or consumption increases, investment will increase by a multiple amount. When income and therefore consumption of the people increases, the greater amount of the commodities will have to be produced.
This will require more capital to produce them if the already given stock of capital is fully used. Since in this case, investment is induced by changes in income or consumption, this is known as induced investment. The accelerator is the numerical value of the relation between the increase in investment resulting from an increase in income.
The net induced investment will be positive if national income increases and induced investment may fall to zero if the national income or output remains constant. To produce a given amount of output, it requires a certain amount of capital. If Yt output is required to be produced and v is capital-output ratio, the required amount of capital to produce Yt output will be given by the following equation:
Kt = vYt …(i)
where K, stands for the stock of capital,
Yt for the level of output or income, and
v for capital-output ratio.
This capital-output ratio v is equal to K/Y and in the theory of accelerator this capital-output ratio is assumed to be constant. Therefore, under the assumption of constant capital-output ratio, changes in output are made possible by changes in the stock of capital. Thus, when income is Yt then required stock of capital Kt = vYt. When output or income is equal to Yt-1, then required stock of capital will be Kt-1 = vYt-1.
ADVERTISEMENTS:
It is clear from above that when income increases from Yt-1 in period t – 1 to Yt in period, t, then the stock of capital will increase Kt-1 from to Kt. As seen above, Kt-1 is equal to vYt-1 and Kt is equal to vYt.
Hence, the increase in the stock of capital in period t is given by the following equation:
Kt-Kt-1 = vYt – vYt-1
Kt-Kt-1 = v (Yt – Yt-1) …(ii)
Since increase in the stock of capital in a year (Kt – Kt-1) represents investment in that year, the above equation (ii) can be written as below:
I1 = V (yt – yt-1) …(iii)
Equation (iii) reveals that as a result of increase in income in any year t from a previous year t- 1, increase in investment will be v times more than the increase in income. Hence, it is v, i.e., capital-output ratio, which represents the magnitude of the accelerator. If the capital-output ratio is equal to 3, then as a result of a certain increase in income, investment will increase three times more, i.e., accelerator here will be equal to 3.
It thus follows that investment is a function of change in income. If income or output increases over time, that is, when Yt is greater than Ft-1 then investment will be positive. If income declines, that is, Yt is less than Yt-1 then disinvestment will take place. And if the income remains constant, that is, Yt = Yt-1 the investment will be equal to zero.
Theory Of Investment Value Pdf
An arithmetical example will make clear the working of the accelerator. This has been represented in the accompanying table.
ADVERTISEMENTS:
We have made the following assumptions in making this table:
(i) Capital-output ratio remains constant and is equal to 3.
(ii) The depreciation that takes place in the stock of capital is equal to one-fifth of the stock existing in the previous year. Therefore, one-fifth of the stock of capital is to be replaced every year.
In the Table 11.1, it is supposed that in period t-1 and several periods before it, output or income is equal to Rs. 500. Given that the capital-output ratio is equal to 3, then to produce ? 500 worth of output, Rs. 1,500 worth of capital will be required. [K = vY; 1500 = 3(500)] which is written in column (3).
Since depreciation of capital occurred in period t-1, it will be one-fifth of the stock of capital existing in the previous period (which is also Rs. 1,500). Therefore, replacement investment in period t-1 will be equal to Rs. 300. Since as compared to the previous period, there is no change in output in period t-1, the net investment in period t-1 will be equal to zero. As a result, the gross investment in period t-1 will be equal to Rs. 300.
Now suppose that production in the period t rises to Rs. 510 crores as a result of increase in Government expenditure or autonomous investment. To produce output worth Rs. 510 crores, total capital worth Rs. 1530 is required [Kt = vYt 1530 = 3(510)] which is written in column (3). Thus, as a result of increase in output (income) by Rs. 10, net investment has increased by Rs. 30, that is, 1530- 1500 = 30 which means that accelerator is here equal to 3.
In period t the depreciation equation equal to 1/5th of the capital stock of period t-1 will occur, that is, capital depreciation of Rs. 300 (1/5 x 1500 = 300) will occur in period t. Therefore, capital replacement investment in period t will be equal to Rs. 300. Thus, gross investment in period t will be equal to 30 + 300 = 330.
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ADVERTISEMENTS:
In this way, if output (or income) increases by Rs. 15 in period t + 1, Rs. 25 in period t + 2, and also Rs. 25 in period t + 3, the net investment will increase by three times the increment in output (or income), that is, net investment will increase by Rs. 45 in period t + 1, Rs. 75 in period t + 2 and also Rs. 75 in period t+ 3.
It will be further observed from Table 11.1 that when output falls in period t + 5 by Rs. 15, the net investment will decline by 3 times of it, that is, equal to Rs. 45. Likewise, from changes in output in different periods we can find out net investment that will take place in any period and with the capital replacement investment we can obtain the gross investment that will occur in any period.
A glance at columns 2, 5 and 6 will show that with a change in output, investment will increase by a multiple of it. This shows that acceleration principle is a powerful destabilizing force working in the economy. If the accelerator is the only force at work, then we shall have too much of instability in the economy—more than is actually found.
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In real life, we find that there are limits to instability, both in the upward as well as the downward direction, so that fluctuations in economic activity or what are called business cycles must have a peak as well as a bottom.
Criticism of the Accelerator Theory:
Theory Of Investment Value
The principle of acceleration has come in for a good deal of criticism in recent years. For example, it has been pointed out by Kaldor that we cannot assume a constant value of the accelerator throughout the trade cycle, that is, it is not true that an increase in output or income by an amount must always give rise to a multiple increase in investment.
This is because, if already, some machines are lying idle, we shall try to use them before rushing in for new equipment. Also, if expectation of entrepreneurs is that the rise in demand brought about by increase in income or output is only a temporary one, they will try to meet it by overworking the existing machinery rather than installing a new plant. Thus, in the theory of accelerator it has been assumed that there is no excess capacity existing in consumer goods industries.
In other words, it has been assumed that no machines are lying idle and no extra shift working is possible. If there had been excess capacity and extra shift working was possible, the supply of goods could be increased with the existing equipment and the accelerator would not come into play.
Further, in the acceleration principle it has also been assumed that in the capital goods industries, there exists surplus productive capacity. If there is no excess capacity in the machine-making industries, increased demand for machines caused by the requirement for additional output would not lead to increase in the supply of machines.
In the absence of supply of machines, investment cannot increase in the short run. It is thus assumed in the accelerator theory that the machine-making industry is capable of increasing its output for the time being at least. The supply can be increased by reducing stocks of finished machines, by working extra shifts, and so on. But stocks cannot be reduced below zero and working double shifts or adoption of other experiments is found to be expensive. Only when the demand has increased permanently, will the entrepreneurs find it worthwhile to increase investment in machine-making industries.
The size of the accelerator does not remain constant over time. Its value will be affected by the businessmen’s calculation regarding the profitability of installing new plants to make more machines on the basis of their probable working life. It is also assumed that the demand for machines will remain stable in future, although the increase in demand has suddenly cropped up.
However, in spite of the above limitations of acceleration principle, it points out an important force which causes economic fluctuations in the economy. Economists like Samuelson, Hicks and Dusenberry have shown how accelerator combined with multiplier provides an adequate and satisfactory theory of business cycles that occur in free market economies.