Free «Liquidity and the Monetary Base» Essay Paper

The Federal government experiences budget deficit when it spends more than what it has collected from taxes. Even though, the liquidity levels could be high in the financial market, the government can face periods of the budget deficit. Considering the attributes of Keynes theory on liquidity trap and that it focuses on employment, interest, and money through the government use of fiscal policy. It is justifiable to give a better economic perspective, as to the main reason why the Federal government experiences budget deficit at times when there is the presence of high liquidity levels in the financial market.

The IS and LM curves under the Keynesian model possibly explains the reason behind the deficits in the government budget while the financial market have a higher level of liquidity. The central bank increases its money supply from the initial equilibrium level E to a lower level E’; it affects the interest rate (Dwivedi, 2010). This is because the interest rate shifts up subsequently from r to r’ because there is a shift in the equilibrium point. Consequently, the output levels in an economy increases from Y to Y’. In most cases, the central bank undertakes an increase in the money supply for a given period. The interest rate, subsequently, increases as the Federal government changes its debt composition by increasing the cash debt (Dwivedi, 2010).

 

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According to the Keynesian theory that focuses on employment, interest, and money the use of fiscal policy by the government to achieve economic stability leads to the deficit in the Federal government budget. When the government decreases its tax collection to achieve economic stability subsequently, people’s income will increase thus, individuals will spend more (Dwivedi, 2010). Keynes notes that inflation rise drastically. Therefore, Keynes advises the government to introduce anti-inflation fiscal policies. This is because the country’s economy experiences high and rising unemployment rates.

One factor that is attributable to Keynesian theory is its suggestion of the use of active government policy as a means of managing the economy. Keynes advised the federal policy makers to use countercyclical fiscal policies’ it is rather better than focusing on a unbalanced government budget that brings about deficit. As a result, Keynes advocated deficit spending in cases where the country’s economy is suffering from recession even if the unemployment rates become persistently high (Dwivedi, 2010). On the other hand, Keynes advises the federal government to suppress inflation rates in economic boom times by taking measures to either increase taxes or cut back on its outlays.

In conclusion, the Keynesian theory explains the reason why the government experiences deficit in a period of high liquidity levels in the financial market. Keynes explains how the control of money supply affects the interest rates that determine a dimension of the monetary policy carefully in order to avoid a budget deficit occurrence in periods of high disposable income that people have with them. It is therefore essential for the government to use the monetary policy carefully in order to avoid a budget deficit occurrence in periods of high liquidity levels in the financial market.