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Why is a high rate of inflation better for weathering effects of a huge govt. debt ?

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  • $\begingroup$ Better for whom? $\endgroup$
    – Giskard
    Apr 22, 2022 at 22:11

1 Answer 1

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Because of several reasons.

A) Inflation reduces the real value of that debt. If government issues \$1000 bond it gets to enjoy \$1000 at current purchasing power, but as inflation reduces value of dollars when the \$1000 is repaid, even though government has to return the nominal value of \$1000 the real value of that money will be lower.

B) Most government debts are fixed income securities. Mostly bonds that pay fixed coupons (equivalent of interest payment). From economic perspective what matters is the real return on your financial instrument. Real return $r$ is approximately nominal return $i$ minus inflation $\pi$ hence $r \approx i -\pi$. Since $i$ is fixed for typical government debt when inflation goes up, real rate of interest goes down.

C) Inflation pushes people to higher tax brackets. This applies only to countries with progressive income tax systems but nowadays most countries have highly progressive income taxes, especially developed countries like countries in EU or USA.

For example, in the USA if you earn about \$40000 per year you have to pay 12% income tax, but if your earnings are above \$40,526 you have to pay 22% income tax (see turbotax). Inflation typically pushes up not just price of goods and services but also wages. For example if you earn \$40000 at time $t=0$ and there is 10% inflation at time $t=1$, to stay at the same standard of living as before inflation your employer would have to raise your annual wage to \$44000. Over long run wages depend on your marginal product so eventually you should get the raise to cover for the effect of inflation. This however suddenly pushes you into much higher tax bracket. This might be bad for you as an individual but it raises government revenue.

D) Depending on source of the inflation government can earn some seignorage revenue from it. Inflation often occurs when government creates too much new money and then spends it (see Mankiw Principles of Economics pp 13). For example, if central bank creates new money by purchasing government bond, government gets to spend that money first before it can have its full effect on price level. In addition, this extra demand for government bonds puts pressure on keeping interest rate government pays on its debt low. Lastly, even though government typically still has to pay interest and eventually principal to the central bank, central bank is in most if not all countries in the world government institution so all profits central bank makes just go back to the government budget.

The reasons A-D make debt burden much more easier. A, and B are probably the most important factors as they directly impact real value of the debt and cost to service it. C and D are less important but not trivial.

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