Fiscal policy is the policy of the government regarding the change in government expenditure and taxation. The main objective of the fiscal policy is full employment, economic growth, price stability, the balance of payment, etc. In the Keynesian system when government expenditure increases there will be the immediate effect of change in investment function i.e. when government expenditure increases investment increases the real output also increases through the multiplier process but the effect of fiscal policy in the economy depends on the conditions of employment in the economy. Therefore, for the explanation of effect of fiscal policy in the Keynesian system, we have to divide the economy with some unemployment and full employment.
i. Effect of fiscal policy in the Keynesian system with some unemployment:
When there is unemployment in the economy, a rise in government expenditure reduces the investment fun to shift upward to the right. When investment increases the real output also increases through the multiplier process. When output increases more labor force are attracted but due to the diminishing returns to labor, the cost of production increases and the general price level also increases. When price level increases real wage rate decreases and the supply function of labor shift downward. This is the initial effect of an increase in government expenditure.
When price level increases nominal income also increases thereby increasing the transaction demand for money. When transaction demand for money increases the money of speculation will decrease and the rate of interest increases and subsequently the supply of money function shift to the left. Ultimately there is the tendency of decreasing the real wage and increasing the saving investment and employment. The effect of an increase in government expenditure depends on the different economic conditions like sources of deficit financing whether the economy is in a liquidity trap or not. The effect of an increase in government expenditure in case of some unemployment can be explained with the help of the following diagram:
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| Effect of Fiscal policy in Keynesian World |
Effect of a cut in money wage to reduce unemployment under Keynesian framework:
We know that in the classical model wage and price flexibility automatically adjust the employment and output in the economy. According to them, there will be downward as well as upward flexibility of wages and prices but according to the Keynesian, there is no possibility of downward flexibility of wages and prices. If there would be a reduction in money wage helps the economy expands. Here we are discussing the effect on the money wage to reduce unemployment in the Keynesian system.
i. Initial Effect:
The initial effect of the reduction in money wage is the decrease in commodity prices (money wage decrease commodity price decrease). This is so because there is a direct link between commodity price and per unit of labor cost. When money wage decreases the cost of labor also decreases and subsequently the commodity price also decreases. When there is a reduction in commodity prices there will be decreased in nominal income (Money wage decreases, the cost of production decreases, price decreases, nominal income decreases). When nominal income decreases the transaction demand for money also decreases. This causes an increase in speculative demand for money. It means the residual supply of money increases and the supply curve shift to the right. Due to this reason, the nominal rate of interest decreases.
ii. Secondary effect:
When the rate of interest decreases investment increases in the economy and it will expand through the multiplier process. Therefore, real output and employment increases or unemployment are reduced. But, when there is expansion in the economy more and more labor force is to be employed. Due to the diminishing return to labor, the cost of production increases the price level also increases. When price level increases there will be a reduction of real wage and supply curve of labor shift downward. In this way, the cut in money wage has the same impact on the interest rate and there will be an expansion in the economy but Keynes argued that flexible monetary policy is superior to flexible wage policy.
iii. Ultimate/ Final effect:
In this way, if the reduction in money wage were successful, money wage, commodity price, and the interest rate would all be smaller lower and the real wage also might be lower while the volume of real output and employment would be higher. If a liquidity trap situation prevails the wage cut would be useless. He had neglected the Pigou’s effect. Therefore, if wage cut is possible the employment can also increase in the Keynesian framework. This can be explained with the following diagram:
