The accelerator, the economic cycle and output gaps

Overview

Recall questions on the accelerator, how the multiplier and accelerator create the economic cycle, output gap calculations and diagrams, and the causes and consequences of output gaps.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Define the accelerator.

   Model answer

   The accelerator is the theory that the level of net investment depends on the rate of change of national income or output rather than on its level.

2. 2

   Firms working with a capital-output ratio of 3 expect output to rise by £20m, then revise that expectation down to a rise of £12m. Calculate induced net investment in each case and explain what the comparison shows.

   Model answer

   Induced net investment falls from 3 × £20m = £60m to 3 × £12m = £36m, a drop of £24m, which shows that investment can collapse while output is still growing, simply because it is growing more slowly.

3. 3

   How does the multiplier appear on the aggregate demand and aggregate supply diagram, and why is the eventual rise in real output smaller than the total shift of aggregate demand?

   Model answer

   The injection shifts the aggregate demand curve to the right by its own size and the multiplier appears as a further rightward shift, but because short run aggregate supply slopes upwards part of the extra demand is absorbed by a higher price level, so real output rises by less than the full horizontal shift.

4. 4

   Explain how the multiplier and the accelerator interact to generate the economic cycle.

   Model answer

   A rise in an injection raises national income by a multiple of itself, the faster growth of income induces extra investment through the accelerator, that investment is itself an injection and multiplies again, so the upswing gathers pace until capacity limits slow income growth, at which point induced investment falls sharply and the same process runs in reverse into a downswing.

5. 5

   An economy has actual output of £1,940bn and potential output of £2,000bn. Define the output gap and calculate it as a percentage of potential output.

   Model answer

   The output gap is the difference between actual and potential output, here £1,940bn − £2,000bn = −£60bn, which is −60 ÷ 2,000 = −3.0% of potential output, a negative output gap.

6. 6

   How do a negative and a positive output gap each appear on the aggregate demand and aggregate supply diagram?

   Model answer

   With a negative gap the intersection of aggregate demand and short run aggregate supply lies to the left of the long run aggregate supply position, leaving spare capacity and weak price pressure, while with a positive gap it lies to the right of that position, so output is above the sustainable level and costs and prices are pushed up.

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