Answer:
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J.M. Keynes challenged the classical economic theory that assumed that the economy would automatically self-correct to full employment equilibrium in the long run. He argued that the economy could experience prolonged periods of involuntary unemployment due to various factors, such as insufficient aggregate demand.
To understand Keynes's explanation, let's consider the 45-degree line diagram. In this diagram, the horizontal axis represents national income or output, and the vertical axis represents aggregate expenditure. The 45-degree line represents the equality between national income and aggregate expenditure.
Following the 1929 stock market crash and the onset of the Great Depression, there was a significant decline in aggregate demand. Keynes argued that this decline in aggregate demand could lead to a situation where the equilibrium level of output falls below full employment, resulting in involuntary unemployment.
In the diagram, assume that the initial equilibrium is at point A, where aggregate expenditure (AE) is equal to national income (Y) but below the full employment level. At this point, there is a gap between the desired level of spending and the actual level of output. This gap represents the shortfall in aggregate demand.
Keynes highlighted the multiplier effect as a crucial mechanism to explain how changes in spending can magnify the impact on the overall economy. According to the multiplier process, an initial change in spending, whether it's an increase or decrease, can have a larger effect on national income.
To address the gap in aggregate demand and stimulate the economy, Keynes proposed increasing government spending or reducing taxes. Suppose the government implements an expansionary fiscal policy by increasing government spending. This would shift the aggregate expenditure line upward.
As a result, the new aggregate expenditure line intersects the 45-degree line at point B, where the level of output increases. This increase in output leads to increased incomes for individuals, who then spend a portion of their income. This additional spending creates a further increase in aggregate demand, causing a positive multiplier effect.
The multiplier effect means that an initial increase in government spending has a greater impact on national income, as the increased income leads to additional spending, which in turn leads to more income and spending. This process continues until the economy reaches a new equilibrium at a higher level of output (point C), potentially approaching full employment.
Keynes argued that through the multiplier process, deliberate government intervention could be necessary to overcome the persistence of involuntary unemployment and bring the economy back to full employment equilibrium.
It's important to note that the 45-degree line diagram simplifies the analysis and does not capture all the complexities of Keynesian economics. Nonetheless, it provides a visual representation of the logic behind Keynes's argument regarding the role of aggregate demand, the multiplier effect, and the need for active government policies to address unemployment during times of economic downturns.
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