[derosa8]

What is the ultimate reason why enormous government debt is bad? Couldn’t we theoretically just keep servicing the debt through taxes and mild inflation over many generations and not cause any catastrophes?

[jmherbener]

Enormous government debt is bad because it transfers an enormous amount of resources from markets, in which they are used efficiently, to the state, in which they are used inefficiently.

The problem with continuing to service the debt when it expands enormously is that doing so takes up an increasing portion of the government’s budget. There comes a point at which it must face a choice between servicing the debt and its other budgetary obligations. Usually, the government delays this choice by monetary inflation. But monetary inflation destabilizes financial markets and causes price inflation, which pushes up interest rates and puts further pressure on the government’s budget from servicing the debt.

But, you’re correct. The government could choose a more prudent course by limiting its other expenditures, running budget surpluses, and retiring debt. If it did so, no catastrophe would inevitably follow.

[derosa8]

Thanks Professor Herbener. You have a remarkable ability to give concise and coherent responses without fail. Continue to provide clarity in Economics! The good Lord knows we need more clarity, especially among younger folks like myself.

[derosa8]

Also, what is the causal link between price inflation and interest rates? Why does price inflation tend to push up interest rates as you say? That sounds somewhat confusing, since we have had a good amount of inflation this past decade, yet interest rates have not risen. Perhaps you mean they would rise in a natural market without the FED keeping them low?

[derosa8]

Just listened to your lecture on the Time Market and I think I now understand the answer to my last post. A decrease in the purchasing power of money brings about a higher interest rate, since lenders must take into account what the money they will be paid with will be worth in the future. Got it. That certainly makes sense on an unhampered market.

But what would be the effects on inflation on interest rates in the type of interventionist market we have?

[rt]

JohnD, here’s the way I see it:
If the Fed creates money out of thin air by purchasing assets, banks acquire deposit accounts at the Fed and have increased reserves. Now that their reserves have increased, they can lend out more money and increase the number of loans they can make. The supply of loanable money increases which causes the price (interest rate) to borrow money to fall (if demand stays the same). Thus monetary inflation (increase in the money supply) can lead to lower interest rates.
At some point the money created out of thin air pushes up prices which is called price inflation. As you said: “A decrease in the purchasing power of money brings about a higher interest rate, since lenders must take into account what the money they will be paid with will be worth in the future.”
I hope this helps. If I happen to be wrong, please correct me Dr Herbener!

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