In a fixed coupon government bond auction, the higher is the demand for the bonds the lower the yields will be at that asset maturity which suggests that higher budget deficits will eventually drive short-term interest rates down.
Answer: False
The answer is False.
The correct answer is that yield will be lower at that asset maturity but this tells us nothing about the effect of budget deficits on short-term interest rates
So the proposition is only partly correct - higher demand for bonds will lower yields.
You may have answered true to the overall proposition by extending your understanding of the fundamental principles of Modern Monetary Theory (MMT) that include the fact that government spending provides the net financial assets (bank reserves) and budget deficits put downward pressure on interest rates (with no accompanying central bank operations), which is contrary to the myths that appear in macroeconomic textbooks about "crowding out".
But of-course, the central bank sets the short-term interest rate based on its policy aspirations and conducts the necessary liquidity management operations to ensure the actual short-term market interest rate is consistent with the desired policy rate. That doesn't mean the central bank has a free rein.
It has to either offer a return on reserves equivalent to the policy rate or sell government bonds if it is to maintain a positive target rate. The "penalty for not borrowing" is that the interest rate will fall to the bottom of the "corridor" prevailing in the country which may be zero if the central bank does not offer a return on reserves.
This situation arises because the central bank essentially lacks control over the quantity of reserves in the system.
So the correct answer is that movements in public bond yields at the primary issue stage, tell us nothing about the intentions of central bank with respect to monetary policy (interest rate setting).
Given that the correct answer includes lower yields the logic developed will tell you why the option "the higher the yields will be at that asset maturity which suggests that higher budget deficits will eventually drive short-term interest rates down" was incorrect.
Why are yields inverse to price in a primary issue? The standard bond has three parameters: (a) the face value - say $A1000; (b) the coupon rate - say 5 per cent; and (c) some maturity - say 10 years. Taken together, this public debt instrument will provide the bond holder with $50 dollar per annum in interest income for 10 years whereupon they will get the $1000 face value returned.
Bonds are issued by government into the primary market, which is simply the institutional machinery via which the government sells debt to "raise funds". In a modern monetary system with flexible exchange rates it is clear the government does not have to finance its spending so the the institutional machinery is voluntary and reflects the prevailing neo-liberal ideology - which emphasises a fear of fiscal excesses rather than any intrinsic need.
Governments are elected to advance a mandate. If that includes maximising welfare of all citizens then we should allow them to do that. If they do not perform well then we can vote them out. We do not need artificial constraints which hinder the government's capacity to advance public purpose - these ideologically conceived restraints represent democratic repression.
Most primary market issuance is via auction. Accordingly, the government would determine the maturity of the bond (how long the bond would exist for), the coupon rate (the interest return on the bond) and the volume (how many bonds) being specified.
The issue would then be put out for tender and the market then would determine the final price of the bonds issued. Imagine a $1000 bond had a coupon of 5 per cent, meaning that you would get $50 dollar per annum until the bond matured at which time you would get $1000 back.
Imagine that the market wanted a yield of 6 per cent to accommodate risk expectations (inflation or something else). So for them the bond is unattractive and under the tender or auction system they would put in a purchase bid lower than the $1000 to ensure they get the 6 per cent return they sought.
Alternatively if the market wanted security and considered the coupon rate on offer was more than competitive then the bonds will be very attractive. Under the auction system they will bid higher than the face value up to the yields that they think are market-based. The yield reflects the last auction bid in the bond issue
The general rule for fixed-income bonds is that when the prices rise, the yield falls and vice versa. Thus, the price of a bond can change in the market place according to interest rate fluctuations.
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