The Multiplier and the Accelerator

Definition and Formulae

The Multiplier Effect refers to the concept that an initial change in expenditure can lead to a larger change in income and output in an economy.
The Multiplier is calculated using the formula 1/MPS (Marginal Propensity to Save) or 1/1-MPC (Marginal Propensity to Consume). The higher the MPC, the higher the multiplier.
The Accelerator Effect suggests that investment levels can change due to changes in the rate of economic growth.
The Accelerator Coefficient is a measure of the responsiveness of investment to changes in income or production.

The Working of the Multiplier

A rise in an injection (investment, government spending or exports) can lead to a larger increase in real GDP. This is known as the Multiplier Effect.
The value of the multiplier depends on the proportion of extra real income that households decide to spend (the MPC). If the propensity to consume is high, leakages from the circular flow will be fewer, and the multiplier will be greater.
Unexpected shocks to an economy can cause large fluctuations in economic activity if the multiplier effect is large.

The Accelerator Theory

The Accelerator Theory suggests that firms adjust their level of investment spending depending on the rate of change of GDP or sales.
For example, if output is growing rapidly, firms might anticipate higher demand in the future and invest more today. Conversely, if output is falling, firms may cut back on investment.
The Accelerator Theory can explain business cycle fluctuations as the decisions of firms to increase or decrease their level of investment can amplify economic upturns or downswings.

Interaction between the Multiplier and the Accelerator

The Multiplier and the Accelerator often work simultaneously in an economy. An initial increase in autonomous investment (due to lower interest rates or optimist business expectations) could increase income. This increased income could then fuel more consumption, leading to a multiplier effect.
A boom in economic activity would then encourage more investment via the accelerator effect, which could then have multiplier effects of its own, leading to a virtuous cycle of economic growth.
However, if the initial change in autonomous spending is negative (such as a drop in exports), then the multiplier and accelerator could combine to cause a severe recession.

Policymakers’ Dilemma

While the Multiplier concept is often used in justifying expansionary fiscal policy, policymakers must be aware that leakages such as saving, import spending, and taxation can reduce the impact of the multiplier.
Also, if the economy is at full employment, trying to use the multiplier effect to stimulate demand can simply cause inflation.
On the other hand, understanding the Accelerator theory can assist policymakers in managing investment and keeping the economic cycle in check. But, unpredictable factors like changes in business confidence and technological progress can make managing the accelerator effect quite complex.