When the government pays back funds that is has borrowed from the non-government sector the payments may
Answer: be inflationary if the government payments to bond holders at maturity add more to nominal aggregate demand than the real economy can support given other policy settings.
The answer is be inflationary if the government payments to bond holders at maturity add more to nominal aggregate demand than the real economy can support given other policy settings..
The option "not be inflationary because the sovereign government just has to credit the bank accounts of those who hold the bonds to repay them" describes the operational reality that accompanies the repayment of the bonds and all interest payments. So in the first place, the flow of funds ends up in bank reserves.
So as it stands that option is a correct answer. But is it the best answer?
The option "be inflationary if by the time the bonds mature the economy is growing strongly so there will be too much money floating about" makes no real sense and is a typical mainstream response. What does "too much money" mean? Nothing as it stands.
The best answer is defined by the crucial assumption that is provides you with. That the funds that accompany the maturing bonds (whether they be the return of the face value or the final interest payment) are spent - that is flow into aggregate demand rather than stay suspended in bank reserves.
An increase in bank reserves is not inflationary. Outstanding public bonds do form part of the accumulated wealth of the non-government sector. At any time, they choose, non-government agents can convert the stock of wealth into a flow of spending. So the "inflation risk" inherent in the stock of financial assets is independent of maturity of the outstanding bonds.
Some might argue that the spending capacity of the private sector is not influenced by when the government repays the bonds. The argument is that the bonds by definition represent savings of the private sector which can be spent at any time regardless of the time to maturity of the outstanding financial assets
But that doesn't negate the validity of the answer in the way I have constructed it. If non-government agents decide to run down some of their financial wealth and start spending then the inflation risk can be realised. I would stress that we should not always focus on that inflation risk as the inevitable outcome. Inflation can result when aggregate demand rises but usually will not.
In this context, it is essential to understand that the analysis of inflation is related to the state of aggregate demand relative to productive capacity.
Increased spending, in itself, is not inflationary. Nominal spending growth will stimulate real responses from firms - increased output and employment - if they have available productive capacity. Firms will be reluctant to respond to increased demand for their goods and services by increasing prices because it is expensive to do so (catalogues have to be revised etc) and they want to retain market share and fear that their competitors would not follow suit.
So generalised inflation (as opposed to price bubbles in specific asset classes) is unlikely to become an issue while there is available productive capacity.
Even at times of high demand, firms typically have some spare capacity so that they can meet demand spikes. It is only when the economy has been running at high pressure for a substantial period of time that inflationary pressures become evident and government policy to restrain demand are required (including government spending cutbacks, tax rises etc).
Further, spending growth can push the expansion of productive capacity ahead of the nominal demand growth. Investment by firms in productive capacity is an example as is government spending on productive infrastructure (including human capital development). So not all spending closes the gap between nominal spending growth and available productive capacity.
But, ultimately, if nominal demand outstrips the real capacity of the economy to respond to the spending growth then inflation is the result.
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