When a government has a budget deficit, it must issue (sell) government bonds to finance the deficit. Does it matter for the rate of inflation if the government sells the government bonds to the public or sells the government bonds to the central bank?
Explain why it does or does not matter.
What will be an ideal response?
It matters greatly. When the government sells the bonds to the public the money supply does not change, but when they sell the bonds to the central bank the money supply increases. If there are large budget deficits, the money supply will increase substantially when the central bank buys government bonds. Using the quantity theory of money, the increase in money supply from the purchase of the bonds by the central bank will increase the inflation rate.
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