Government deficit financing is made easier by a p-percentage-point rise in inflation if it raises the nominal interest rate by ________ than p percentage points,and the private sector wishes to hold ________ quantity of real government bonds.

Question

Quizplus · Accepted Answer

If the nominal interest rate rises by the same amount as the inflation rate, the real interest rate remains unchanged, and therefore the private sector will be willing to hold the same amount of real government bonds. This means that deficit financing will not become more difficult. In fact, a small inflationary increase may even make it easier to finance the deficit. Choice A is incorrect because if the nominal interest rate rises by less than the inflation rate, the real interest rate decreases, which may lead to a decrease in the demand for government bonds. Choice C is incorrect because if the private sector wishes to hold a lower quantity of real government bonds, it suggests that the demand for government bonds has decreased, making it more difficult to finance the deficit. Choice D is incorrect because if the private sector wishes to hold the same quantity of real government bonds despite the inflation increase, it suggests that the demand for government bonds has remained the same, and thus the inflation increase has not made deficit financing easier.

Government Deficit Financing Is Made Easier by a P-Percentage-Point Rise