Monday, August 24, 2009

Role of Acceleration Principle in Trade Cycle

As we know that the accelerator is the numerical value of relation between an increase in income and the resulting increase in investment.

When an initial investment of Rs.100 leads to a rise in income by Rs.400, people’s spending power also rises by an equivalent amount. This will induce them to spend more on goods and services. When the demand for goods rises, initially this will be met by over working the existing plant and machinery. All this leads to an increase in profits with the result that businessmen will be induced to expand their productive capacity, they will install new plants i.e. they will invest more than before. Thus a rise in income leads to a further induced increase in investment.

An example will make the working of the accelerator clear. Suppose that we are living in a world where the only commodity produces is cloth. Further, suppose that to produce cloth work Rs.100, we require one machinery worth Rs.300 which means that the value of accelerator is 3 i.e. if demand rises by Rs.100, additional investment worth Rs.300 takes place. If the existing level demand for cloth remains constant, let us say at Rs.500, then to produce this much of cloth we need five machines worth 1500 rupees. At the end of one year, let us suppose that one machine becomes useless as a result of wear and tear, so that at the end of one year, gross investment of Rs.300 must take place to replace the old machine in order that the stock of capital is capable of producing out put worth Rs.500.

In the third period, demand rises to Rs.800 to produce output worth Rs.800, we need 8 machines point our previous stock consisted of only 5 machines. Thus if we are to produce out put worth 800 rupees. In addition, since at the end of one period one old machine has become useless, even to maintain previous stock of 5 machines, we need to install one new machine in place of the old one. Thus net investment will be 900 rupees and replacement investment 300 rupees so that our gross investment rises 300 rupees in period 2 to 1200 rupees in period 3. A 60% rise in demand gives rise to 400% increase in gross investment. Here we have a glimpse of the powerful destabilizing role of accelerator.

In the fourth period demand rises from 800 rupees to 1000 rupees (25%) but total gross investment is only 900 rupees which is 25% less than the third period. In the fifth period even though demand remains constant at 1000 rupees gross statement fall to 300 rupees which is 33.3% of the fourth period while net investment falls to zero. Thus in order to keep the economy prosperous mere standing sills running at a slow pace is not good. We must run and run faster and faster in order to ward off the danger of a depression. This is because of the extremely destabilising role of the accelerator.

In the acceleration principle, we find a powerful explanation of the destabilising forces working in the economy during a trade cycle. If the accelerator is only force at work, then we will have too much of instability in the economy more then is actually found. In real life, we find that there limits to instability both in the upward and in the down ward directions so that the trade cycle must have a peak as well as bottom.

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