When a government has a large budget deficit, it must issue government bonds to finance the deficit. Explain if it matters for the rate of inflation if the government sells the bonds to the public or sells the bonds to the central bank?
What will be an ideal response?
Whether the government sells bonds to the public or to the central bank matters greatly with respect to inflation. When the government sells bonds to the public, the money supply does not change, but when the bonds are sold 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 the money supply from the purchase of the bonds by the central bank will increase the inflation rate.
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