Question

Explain the acceleration theory of investment. Give its shortcomings.

Answer 1

The Acceleration Theory of Investment explains that investment demand is driven by changes in output or demand for consumer goods. According to this theory, when there is an increase in consumer demand, firms experience higher sales and thus need to expand their production capacity. This leads them to invest in new capital goods. The key idea is that investment accelerates or increases more than the increase in demand, because additional investment is needed to produce the extra output.

However, this theory has several shortcomings:

1. It assumes that firms will always invest when demand increases, ignoring other factors like profitability or interest rates.
2. It presumes a direct, proportional relationship between output changes and investment, which may not hold in real situations.
3. The theory overlooks the role of expectations and uncertainty in investment decisions.
4. It ignores the time lag in adjusting capital stock.
5. It does not consider financial constraints or external economic conditions that might limit investment.