Fiscal policy is an economic tool used in stabilization of economy in a nation. It involves the use of government expenditure, transfer payments and taxation to influence, control and directs the economy(Weil, 2008). The government will decide on the goods and services to purchase, the transfer payments it distributes or the taxes it levies from the public, thus engaging in fiscal policy. Fiscal policy, depending on the state of the economy can either be expansionary or contractionary depending on the desired or target economical goal.
The classical economists believed that Say’s law; “supply creates its own demand” and the flexibility of interest rate would ensure that spending would be adequate to maintain full employment(Weil, 2008). On price flexibility, they believed that prices are flexible and that any market imbalance is short-lived. The adjustment to equilibrium is accomplished automatically through the market of demand and supply. About the wages, their flexibility rate keeps the labor market in equilibrium all the time. If supply of labor exceeds firm demand then wage paid to workers would fall to ensure full employment of work force.
The classical economists could not explain the severity and the prolonged economic recession. There were millions of people out of work thus beating the logic of wage flexibility argument. During recession interest rates tend to rise due to economic uncertainties and this affects the rates of savings and investment.
John Keynes argued that prices are inflexible. It is because sellers are unwilling to accept lower prices thus preventing markets from eliminating shortages and surpluses. He also argued that interest rates were not perhaps the only factor affecting savings and investment. Wages are not flexible, only those willing to work at a low wage will remain in employment with a pay cut.
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