Public Economy the Percentage of Term Paper

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The government of Canada has outstanding debt of approximately $550 billion. To service the debt, it issues bonds. The government has also announced previously that it is committed to fighting inflation. Please explain clearly how government debt management policy can lend credibility to the government's fight against inflation. In doing so, provide a clear explanation of the key differences between indexed and nominal debt.

When a government wishes to curb inflation, one of the most effective ways to use the monetary supply to do so is to sell securities, in short through the sale of government bonds. By selling government securities, the government takes money or liquid capital out of the economy, and makes it more attractive to save rather than to spend money. Also, selling government bonds can reduce government debt. Reducing government debt is an important goal for any administration because the higher the debt, the less that nation's currency is usually valued abroad. Ordinary citizens will have to pay more for imported goods, which makes the cost of living even higher. Inflation is dangerous for the pocketbooks of citizens because wages tend to go up at slower pace than prices.

Nominal debt is debt that is not adjusted for inflation. Indexed debt is adjusted for inflation.

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"The most compelling argument in favor of indexation" of bonds, "is that it eliminates a government's incentive to inflate the economy in order to reduce the real cost of nominal liabilities. Nominal debt, however, allows the government the possibility of hedging against unexpected shocks that affect the fiscal budget and hence reduce tax distortions" (Alfaro & Kanczuk, 2003, p.1). In other words, a government with a high tax burden might be tempted to overheat the economy, because that would make its debt worth less, despite the long-term dangers this could do to consumer's economic health and the health of the currency.

Regarding the sale of bonds economists who advocate the indexation of government debt instruments such as the sale of securities argue that indexing bonds "removes the incentive to inflate' (Alfaro & Kanczuk, 2003, p.1). Attempts to reduce real debt burdens by generating unanticipated inflation are self-defeating when government liabilities are indexed. Governments, therefore, are more likely to focus on reasonable price stability as the appropriate monetary policy objective. Indexed bonds may, thus, enhance monetary policy credibility and in so doing reduce funding costs by the amount of the inflation risk premium incorporated in conventional bonds" (Alfaro & Kanczuk, 2003, p.1).

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