Economics 102

Assignment no. 02

Submitted to

Henry Coultar

Submitted by

Id#S111286

Due date

February 20,2013
Question: Explain how business cycles can be explained using the multiplier –
accelerator theory.

Ans:

Business Cycle:
Business Cycle is the frequent and fluctuating levels of economic activity that an
economy experiences over a long period.
The five stages of the business cycle are growth (expansion/Boom), peak, recession
(contraction), trough and recovery.
Business cycles are measure by considering the growth rate of real gross domestic
product.

GDP: Gross domestic product is the total market value of the final goods and services
that produced within a nation during a given year. It measure of the overall performance
of an economy.

Nominal GDP, measured at actual prices.

Real GDP, calculated in constant prices.
Potential GDP, maximum that can produce and maintain constant price.

Business cycle occurs when there is a difference in real GDP and Potential GDP. The
difference is the GDP gap.

Real output

Peak
Potential GDP
Real GDP
Peak
Expansion

Peak GDP
gap
Recession

Trough

Trough

Time

Figure: Business Cycle

Business cycle theories: Four categories of business cycle theory-

1. Exogenous: In an economic model, an exogenous change is one that comes from

outside. Cases of the cycle lie outside the economy. Such as- wars, oil prices,
election

2. Endogenous: the reason for the cycle is due to inside the economy system. an
important case is the Multiplier and Accelerator Theory

3. Demand induced cycle: shock in AD cycles. As consumer, business, and

government change total spending cycle are created.

Price level

Full capacity
AS

E
E1

AD
AD1
GDP

AD declines, from AD to AD1,

Equilibrium point moves from E to E1. It shows a decline in AD leads to an Economic
downturn.

4. Monetary theories: Cycles are created by the expansion and contraction of money
and credit.
 Explain business cycle using multiplier and accelerator theory:

Multiplier and Accelerator Theory:

The multiplier alone cannot explain the cyclical nature of the business cycle. Interaction
of multiplier and accelerator explains the emergence of different phase of business cycle.

The multiplier tells us that a change in the level of independent investment brings
about a relatively greater change in the level of national income. An increase in
investment will increase GDP by an amplified or multiplied amount.

Change in I (investment) = change in y (income)

The accelerator theory states that the current investment spending depends positively
on the past change in income.

It = a (yt-yt-1) It= investment in time period t

a= Accelerator coefficient

(yt-yt-1)= change in income during

period t

The concept of accelerator is not competitor to the concept of multiplier. They are parallel
concepts. The multiplier shows the effect of changes in independent investment to
changes in income’ and employment. The accelerator shows the effect of changes in
income to changes in induced investment.

A certain amount of independent investment injected into the economy. This will generate
an expansion of income many times greater than it will because of the operation of the
multiplier. The increase in income would lead to rise in demand for consumer goods. The
increase in demand for consumer goods will increase in supply and increase in
investment. The increase in investment would be much more than the increase in demand
for consumer goods due to the operation of the accelerator.
The interaction of the multiplier and accelerator sets in the upward of the business cycle.
This continues until capacity of the economy reached. (Boom)

The rise in income and employment does not continue for a long time. The rise in income
and employment progressively slows down. The reason is that the marginal propensity to
consume starts declining with the rise in income in the upward swing of the business
cycle. A decrease in consumption will result into a greater decrease in investment because
of reverse working of the accelerator. A decrease in investment would lead to a greater
decrease in income due to the multiplier. In short, the combination of reverse working of
the accelerator and multiplier sets in downward swing in the business cycle. This
produced a recession until a trough is reached.