The Role of Government Bonds in the Economy

When the U.S. government issues bonds, it is essentially taking out a loan from the people who buy them. The money from bond purchases can be used to pay for government operations and projects. Bonds are available to U.S. citizens and businesses and foreign investors and governments.

The amount of money circulating in the national economy is the economic money supply. When this supply is too high, there is too much money in the economy -- this may create upward price pressure on goods and services and a steady rise in inflation, decreasing the value of the dollar. The Federal Reserve Board can decrease money supply by selling bonds it already owns. By doing so, it attempts to decrease upward price pressure, curb inflation and increase the value of the Dollar.

When the economy is growing too slowly, or is in a recession, the economic money supply is too low. This leads to an imbalance in the supply and demand for goods and services; supply is too high and demand too low. This can have an negative impact on the economy, causing job losses and wage reductions. In the case of slow economic growth or recession, the Fed buys government bonds to increase the economic money supply. By doing so, it attempts to increase demand for goods and services, avoid job losses and prevent the economy from slowing even further.

When the Fed decreases money supply by selling bonds, it raises interest rates. This increases the amount of money that banks are required to keep on hand in reserve requirements to cover their liabilities. Increased reserve requirements leave banks with less money to lend to consumers. This discourages borrowing and slows an economy that is growing too rapidly. When the Fed increases the money supply by purchasing government bonds, it decreases interest rates, which lowers the reserve requirements for banks. This leaves banks with more money to lend to consumers, encouraging borrowing and stimulating economic growth.

State and local governments also issue bonds, called municipal bonds. The proceeds from the sale of these bonds fund statewide and local projects, such as the maintenance and repair of public utility infrastructures. By funding these projects through the sale of bonds, state and local governments can avoid raising income, sales or property taxes to pay for project costs. Increased taxes can be potentially damaging to state and local economies as they may induce residents to move to an area with lower taxes. Higher taxes also discourage new business growth with business owners choosing to operate in areas with lower taxes.