UNIT 2 THEORIES OF INVESTMENT
acceleration hypothesis was put forward by Clark in 1917, the original idea of the principle is traceable to the works of Aftalion in 1911.
Two versions of the acceleration hypothesis can be distinguished. These are:
(1) The fixed accelerator and (2) the flexible accelerator
The fixed accelerator is characterised by two distinguishing features based on the underlying assumptions. In the first case, there is an assumed fixity of the ratio of current desired capital stock to current output. This can be expressed as:
K = Kt
*
/ Yt………. (3.3)
Where K* is the designed capital stock and Yt is current level of output.
Equation (3.3) can be written as:
Kt* = kYt……….. (3.4)
Equation (3.4) expresses a firm’s desired capital stock as a proportion of the output in the current period, where k is the factor of proportionality.
The stability or otherwise of Equation (3.4) depends on the value of k, the actual values of which is a function of the time period within which the analysis is carried out. Longer time frame for the analysis makes the value of k approaches zero.
We can derive the second versions of the fixed accelerator model by assuming that current net investment equals the value of discrepancy between the capital stock desired in the current period and the actual capital stock in the previous period. Under this assumption, we have:
It = K*t - Kt-1 = ΔK……… (3.5) A net investment rate that guarantees the optimality of capital stock would yield:
Kt-1= K*t-1 = kY t-1……… (3.6) Substitution of Equation (3.6) into (3.5) yields:
It = kYt - kYt-1 = kΔYt……….(3.7) Equation (3.7) is the accelerator expressions. It relates net investment to a change in the level of output. It specifies net investment as being proportional to the discrepancy between the actual level of income in the current period and the level of income in the immediate past period, the factor of proportionality being k, the assumed-fixed-capital-output ratio.
It is this constant that is known as the accelerator and provided it is positive, even small changes in output will have an “accelerated” effect on net investment. If for example, output increases by N20 and k = 2 then this will result in a net investment of It = 2 (20) = 40 increase.
Equation (3.7) above can be specified in gross rather than net terms.
Doing this will yield:
IGt = k (Yt – Yt-1) + Dt……… (3.8) Where Dt is disposable investment.
Equation (3.8) shows that gross investment, Igt is proportional to the discrepancy between the current level of income and the level of income in the previous periods plus disposable investment, being the investment that is made to accommodate the depreciation suffered by capital goods in the course of usage.
Shortcomings of the accelerator theory
Although simple and elegant in exposition, numerous criticisms of the theory have been advanced. Among these are those criticisms that question the validity of the assumptions of the theory. These include:
1. Assumption of Fixed-Capital-Output-Coefficient. This assumption is considered grossly unrealistic as firms do not necessarily operate under the conditions of constant returns to scale implied by it. Moreover, it ignores the possible effect technological advancement can have on the capital output ratio.
Indeed, technical progress can have the effect of lowering the amount of capital needed for a specific level of output.
2. The theory assumes that capital additions are instantaneous. This assumption effectively ignores the possible existence of lags in the process of adding to capital stock. These lags could be due to time lag between capital ordering and capital building.
3. It assumes that firm’s capital stock is at any time fully employed.
This is a grossly unrealistic assumption because in practice, firms are usually able to meet some of their increased demand by working existing machines harder, using whatever idle capacity exists in the process. In fact for an undeveloped country like Nigeria, this assumption is even more unrealities because “apart from the tradition of installing plant size that allows for idle capacity in order to provide for flexibility in production, scarcity of raw materials, balance of payment difficulties and high cost of funds necessarily force firms to operate at below installed capacity. The existence of idle capacity creates a gap between actual and potential output and so breaks down the simple accelerator principles”.
4. The hypothesis ignores the role of expectations in investment decision making. If investors expect a positive change in aggregate demand to be temporary, such increase might not elicit investment spending from them. However, an optimistic business outlook would make businessmen increase their investment outlay consequent upon an increase in aggregate demand (income).
SELF-ASSESSMENT EXERCISE
Explain the two versions of the acceleration hypothesis.