Suppose a firm has enough capacity to continue to produce the amount it is currently selling but doesn’t expect its sales to grow in the future. Then it will engage in investment spending only to replace existing equipment and structures that wear out or are rendered obsolete by new technologies. But if, instead, the firm expects its sales to grow rapidly in the future, it will find its existing production capacity insufficient for its future production needs. So the firm will undertake investment spending to meet those needs. This implies that, other things equal, firms will undertake more investment spending when they expect their sales to grow.

Now suppose that the firm currently has considerably more capacity than necessary to meet current production needs. Even if it expects sales to grow, it won’t have to undertake investment spending for a while—not until the growth in sales catches up with its excess capacity. This illustrates the fact that, other things equal, the current level of productive capacity has a negative effect on investment spending: other things equal, the higher the current capacity, the lower is investment spending.

If we put together the effects on investment spending of growth in expected future sales and the size of current production capacity, we can see one situation in which we can be reasonably sure that firms will undertake high levels of investment spending: when they expect sales to grow rapidly. In that case, even excess production capacity will soon be used up, leading firms to resume investment spending.

What is an indicator of high expected growth of future sales? It’s a high expected future growth rate of real GDP. A higher expected future growth rate of real GDP results in a higher level of planned investment spending, but a lower expected future growth rate of real GDP leads to lower planned investment spending. This relationship is summarized in a proposition known as the accelerator principle. As we explain in the upcoming Economics in Action, in 2006, when expectations of future real GDP growth turned negative, planned investment spending—and, in particular, residential investment spending—plunged, accelerating the economy’s slide into recession. Generally, the effects of the accelerator principle play an important role in investment spending slumps, periods of low investment spending.