In the chapter opener, you learned that the U.S. government had more than $16 trillion in debt outstanding in the form of Treasury bills, notes, and bonds in 2013. From time to time, the Treasury changes the mix of securities that it issues to finance government debt, issuing more bills than bonds or vice versa.
a. With short-term interest rates near 0 percent in 2013, suppose that the Treasury decided to replace maturing notes and bonds by issuing new Treasury bills, thus shortening the average maturity of U.S. debt outstanding. Discuss the pros andcons of this strategy.
b. The average maturity of outstanding U.S. Treasury debt is a little more than 5 years. Suppose that a newly issued 5-year Treasury note has a coupon rate of 2 percent and sells at par. What happens to the value of this bond if the inflation rate rises 1 percentage point, causing the yield-to-maturity on the 5-year note to jump to 3 percent shortly after it is issued?
c. Assume that the “average” Treasury security outstanding has the features described in part b. If total U.S. debt is $16 trillion and an increase in inflation causes yields on Treasury securities to increase by 1 percentage point, by how much would the market value of the outstanding debt fall? What does that suggest about the incentives of government policy makers to pursue policies that could lead to higher inflation?