Price Level and Public Debt:

When government undertakes borrowing competing the private sector, the interest rates tend to rise. Consequently the cost of borrowing in the economy does increase leading to an increase in the price level. This is one of the reasons why economists often advise the governments to reduce the fiscal deficit to a rational and reasonable level.

Price level or inflationary situation has an important relationship with the term structure of the bonds and securities. According to Musgrave the inflation drives up the rates because lenders would try to protect themselves against any possible loss in the real value of their claims as prices rise.  For example, if the real rate of return in the absence of any price rise is 3 per cent, and if the expected price rise or inflation is 6 per cent, the nominal rate of interest will be 9 per cent.  So the price rise has lessened the net gain in real terms.  Also if inflation is expected to slow down it will lead to a fall in long rates relative to short rates and vice versa. 

Price rise or inflation also amounts to be a method of debt redemption. It means the real value of public debt depreciates because of a fall in the value of the monetary standard due to inflation consequent upon a currency expansion.  If the government tries to liquidate the debt by a method of currency expansion it will loose its credibility and future borrowing may be difficult to the government.  The central bank has to guarantee and provide unlimited support to the government bond market in order to stabilize the prices of government bonds, in an underdeveloped economy.  But such a policy may have inflationary impact on the economy.