Question

John Maynard Keynes proposed that the multiplier effect can correct an economic depression. Based on this theory, an increase in equilibrium output would be created by an initial a. increase in investment. b. increase in government spending. c. decrease in government spending. d. both (a) and (b). e. both (a) and (c).

Short answer

Based on the Keynesian multiplier effect, both an increase in investment and an increase in government spending would lead to an increase in equilibrium output. Therefore, the correct answer is \(d. \text{both (a) and (b)}\).

Step-by-step solution

The Keynesian multiplier effect is the idea that an initial change in spending (either investment or government spending) can lead to a larger shift in equilibrium output, income, and employment. According to John Maynard Keynes, this multiplier effect can help to restore economic equilibrium and correct an economic depression. #Step 2: Analyze the given options#

In this exercise, we are given 5 options about which action would lead to an increase in equilibrium output based on the Keynesian theory: a. increase in investment b. increase in government spending c. decrease in government spending d. both (a) and (b) e. both (a) and (c) #Step 3: Evaluate the options#

We can now evaluate each option in light of Keynesian theory. a. Increase in investment - According to Keynes' multiplier effect, an initial increase in investment would lead to a larger shift in equilibrium output. b. Increase in government spending - Similarly, an increase in government spending would also cause a shift in equilibrium output due to the multiplier effect. c. Decrease in government spending - The decrease in government spending would not cause an increase in equilibrium output as it contracts the total expenditure in the economy. d. Both (a) and (b) - This option correctly states that both an increase in investment and an increase in government spending would lead to an increase in equilibrium output. e. Both (a) and (c) - This option is incorrect as it includes the decrease in government spending, which would not lead to an increase in equilibrium output. #Step 4: Choose the correct answer#

Based on our evaluation of the options, we can now conclude that the correct answer is: d. both (a) and (b), as both an increase in investment and an increase in government spending would lead to an increase in equilibrium output according to Keynes' multiplier effect.

Key concepts

Economic Depression

An economic depression is a severe and prolonged downturn in economic activity. Usually, it is characterized by a significant fall in gross domestic product (GDP), high unemployment rates, a decrease in consumer spending, and a scarcity of available credit. During this period, businesses may close down, and the economy struggles to reach full capacity production.

Keynesian economics suggests that during an economic depression, governments should undertake active fiscal policies, such as increasing investment and government spending, to stimulate demand. This approach contrasts with allowing the market to self-correct, which can potentially prolong the downturn.

The rationale behind this is to jumpstart economic activity by boosting demand, which can then lead to increased production, employment, and eventually, stabilize the economy.

Equilibrium Output

Equilibrium output refers to the level of production at which aggregate supply equals aggregate demand in an economy. In simpler terms, it's where what is being produced is equal to what consumers want to buy, preventing the build-up of goods or shortage of products.

According to Keynesian theory, this equilibrium can be troubled during times of economic instability, such as a depression or recession.

This is where the Keynesian multiplier comes into play. By stimulating certain types of spending, such as investment and government expenditure, the economy can be nudged back toward its equilibrium output level. This, in turn, helps in reducing unemployment and utilizing resources efficiently, bringing stability to the economy.

Government Spending

Government spending plays a crucial role in shaping an economy's performance, particularly in times of economic trouble. When a government decides to invest in infrastructure projects, public services, or other spending initiatives, it injects money directly into the economy.

This injection can lead to a chain reaction of increased economic activity. For example, when the government spends on building new roads, it generates employment for workers, demands materials from suppliers, and hence increases income for both, leading to further spending.

The idea is that this spending multiplies its effect across the economy, which is why it's known as the Keynesian multiplier. By boosting this type of expenditure during a slump, the government can effectively lift the equilibrium output and help move the economy out of a depression.

Investment

Investment is the allocation of resources, like capital, to generate significant returns over time. It can include spending on new technology, machinery, or infrastructure by private businesses or individuals.

In the context of the Keynesian multiplier, investment is vital as it is seen as a prime method to stimulate economic growth. For example, when businesses invest in machinery or technology, they not only improve their productivity but also create jobs, as more workers are needed to operate the new machinery.

As these workers earn income, their spending increases, leading to higher demand for goods and services and prompting further investment.

This creates a positive cycle that moves the economy towards higher equilibrium output. In periods of economic depression, encouraging investment can be one pathway to expedite recovery and sustain long-term growth.