Let’s assume an economy has 0% inflation, and people expect inflation to remain at 0%.
Then let us assume the government needs to borrow £2bn by selling 30 year bonds worth £1,000 to the private sector. To attract people to buy bonds, the government may offer an interest rate of 2% a year.
The government will then have to pay back the full amount of the bonds £1,000, plus the annual interest payments on these bonds (£20 a year at 2%).
The investors who buy the bonds will make a profit. The bond yield (2%) is above the inflation rate. They get back their bonds plus the interest.
However, suppose, unexpectedly there was inflation of 10%. This reduce the value of money. As prices go up because of inflation, £1,000 would buy a lower quantity of goods and services.
Because of inflation, the government would get more tax revenue as wages and prices increase (e.g. if prices go up 10%, the governments VAT receipts will increase 10%), (if incomes increase 10%, income tax receipts will, roughly, increase 10%. Therefore, inflation helps government automatically get more tax revenue.
- Because of inflation, the government see its nominal tax revenues increase.
- The country isn’t better off, prices are just higher.
However, bond holders lose out. The government still only have to pay back £1,000. But, inflation has reduced the value of that £1,000 bond (real value is now £900.) The inflation rate (10%) is higher than the interest rate (2%) on the bond, so they are losing the real value of their savings.
Inflation means that repaying bond holders requires a smaller % of government total tax revenue – so it is easier for government to pay back.
The Government (borrower) is better off, bond holders (savers) are worse off as a result of inflation.
Long Term Implications
If people buy bonds expecting low inflation, but then lose their real value of savings because of high inflation, they will become reluctant to buy bonds because they know inflation can reduce the value of bond holders savings.
If bond holders fear government may cause inflation, then they will want higher bond yields to compensate for the risk of losing money through inflation. Therefore the prospect of high inflation can make it more difficult for the government to borrow.
Note: bond holders may not expect zero inflation, what damages bond holders is unexpected inflation.
Example Post War Britain
In the 1930s, inflation was very low. This is one reason why people were willing to buy UK government bonds at low interest rates (in the 1950s, national debt increased to over 230% of GDP). In the post war period, the debt burden was to some extent reduced by the effects of inflation which made it easier for government to meet its repayments.
In the 1970s, unexpected inflation (from oil price shock) helped to reduce governments debt burden in various countries such as US.
Economic Growth and Government Debt
Another issue is that if the government reflate the economy (e.g. pursue quantitative easing) this may also stimulate economic activity as well as inflation. Higher GDP is a key factor in helping government gain more tax revenues to pay back debt.
Bond holders may be nervous of an economy that is predicted to have deflation and negative economic growth. Although the real value bonds can increase with deflation, they may fear the economy is stagnating too much and so the government will struggle to meet its debt.