Simultaneous Operation of the Multiplier Business Cycles

Show that the simultaneous operation of the multiplier and accelerator can cause income Auctions.

Business conditions never remain unchanged. Prosperity may be followed by depression or a crash. Economic expansion yields place to recession, with consequent fall in national output or GNP, employment, and real incomes. Prices and profits may fall. People are thrown out of jobs and idle capacity appears in major preaches of industry.

Ultimately, the bottom is reached and recession starts, the recovery may be faster or slow. It may be incomplete, or very strong, and may be faster or slow may ultimately lead to a new boom. The new prosperity may represent a long sustained situation of high demand, plentiful jobs and improved living standards. Alternatively, it may represented a quick, inflationary rises of prices and speculation to be followed by another crash or panic.

Such upward and downward movements in output, general price level, and unemployment have characterised the non-socialist (or capitalist) coun­tries of the world in the last two centuries. Such movements constitute what we broadly call business (trade) cycles.

In fact, business cycles refer to fluctuations in the level of economic activity (actual GNP) alternating between periods of depression and boom conditions.

The business cycle has four phases:

(a) Depression refers to a period of rapidly falling aggregate demand accompanied by very low rates of output and heavy unemployment,

(b) Recovery refers to an upturn in aggregate demand accompanied by rising output and a fall in unemployment,

(c) Prosperity is the third phase of cycle. During this phase aggregate demand rises and then exceeds sustainable output levels (poten­tial or full employment GNP). Full employment is reached and the emer­gence of excess demand caused the general price level to rise (inflation),

(d) Finally there is recession.

This phase is reached when boom comes to an end. In fact, boom is followed by recession. Aggregate demand falls, bring­ing with it, initially, modest falls in output and employment, but then as demand continues to fall, there is the onset of depression and the cycle is complete.

The Acceleration Principle:

This principle, developed by J.B. Clark in 1917, is basically a theory of the determinants of investment. According to this principle, society’s required capital stock (consisting of inventories and fixed .assets like machines) depends primarily upon the level of production.

Net investment or net addition to the stock occurs, when output is growing. If output is high but fails to grow, net investment will be zero. Consequently, a period of pros­perity may suddenly come to a halt, not simply because sales have fallen, but merely due to the fact that production and sales have remained at a high level.

A simple example will make the point clear. Let us consider the case of a textile producer who requires two extra units of capital to produce one extra unit of output. His capital-output ratio is 2. So, he has to keep a capital stock which is always double the level of output (or sales) of clothing.

Thus, when its sales have remained at Rs.30 lakh per year for some time, it capital stock its sales remained at Rs. 30 lakh per year for some time, its capital stock will be of Rs. 60 lakh. This may consist of 20 machines of Rs. 3 lakh each.

We also make the assumption that one machine wears out every year and ahs to be replaced. In other words, the rate of depreciation is Rs. 3 lakhs. In this simple example there is not ne investment by the firm as long as output or sale of clothing remains unchanged. In other words, just gross investment to the extent of depreciation takes place.

Let us now suppose that, after few years, sales rise by 50% from Rs. 30 lakh to Rs. 45 lakh. Now, in order to produce this extra output, the firm requires 30 instead of 20 machines. Thus, it will have to order 11 machines—1 machine for depreciation or replacement purposes and 10 new machines for producing the extra output of Rs. 15 lakh.

Now, we see the operation of the acceleration principle. A modest 50% income in sales here leads to 1,000% increase in gross investment—from 1 machine per annum to 11 machines. This accelerated effect on investment of a small change in output or sale of consumption good is the essence of the accelerator principle.

If sales keep on increased by 50% for the next one or two years, the firm will need 11 new machines each year.

So far the accelerator principle has worked quite well. It has led to a tremendous increase in investment spending in response to a modest in­crease in sales. But, now we are in trouble. According to the principle, sales must keep on increasing year after year at the same rate for the rate of investment to remain unchanged.

If sales fail to grow at the same rapid rate or if sales stabilise at a very high level after some time, then net investment will always fall to zero. Only gross investment of Rs. 3 lakhs (or 1 machine) will take place year after year rather automatically.

In other words, a mere stabilisation (or leveling off) of sales leads to 90% drop in gross investment (from 11 machines to 1 machine) and a 100% drop in net investment (from 10 machines to zero machine).

Like the multiplier, the accelerator principle can work in both the direc­tions. If sales fall below a particular level (after remaining fixed at that level for some time) gross investment will fall to zero. In fact, the firm would now be induced to sell out some of its machines which are no longer required. This is virtually an act of negative investment (or disinvestment). Hence, investment can fall sharply because output has stopping growing. This fall in investment may cause business recession.

According to P.A. Samuelson and W.D. Nordhaus, “The accelerator principle is a powerful factor causing economic instability. Change in output may become magnified into larger changes in investment.”

The interaction of the multiplier with the accelerator:

Paul Samuelson has developed in 1930 an important theory of the business cycle by combining the two fundamental principles of macroeconomics— the multiplier and the accelerator. To understand Samuelson’s basic model, one may consider what happens when there is a fall in production of textile producing machines in the event of a drop in the demand for textiles. (It has to be noted that the demand for a capital goods is a derived demand and the accelerator principles is derived from this proposition.)

The fall in the production for such machines will lead to a fall in expenditure on food and clothing of those people whose resources remain idle. This will lead to a further (multiplied) fall in output of clothing, a further (accelerated) drop in net investment and so on.