Assume that a country’s government increases borrowing. What will most likely happen to the prices of previously issued bonds and the price level in the short run?
BP- decrease PL- Increase
In the short run, an increase in government borrowing is likely to have two main effects:
1. Increase in bond yields: When the government issues more debt, it creates an excess supply of bonds in the market. This tends to lower the price of bonds and increase their yields, as investors demand a higher rate of return to compensate for the increased risk of inflation and default. As a result, bond prices of previously issued bonds will decline and their yields will increase.
2. Increase in price level: An increase in government borrowing can also lead to an increase in the price level in the short run. This is because the government will spend the funds it borrows, which increases the demand for goods and services. As demand rises, prices tend to rise, causing inflation.
Overall, in the short run, an increase in government borrowing is likely to lead to higher bond yields and lower bond prices, and an increase in the price level. However, in the long run, the impact on the economy will depend on a variety of factors, including the purpose of the borrowing, the ability of the government to repay its debt, the effect on interest rates and inflation, and the impact on economic growth.
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