Question

If a government gains from unexpected inflation when it borrows, why would it choose to offer indexed bonds?

Short answer

The government would choose to offer indexed bonds even when it gains from inflation because the interest rate is guaranteed on index bonds and the inflation rate has no influence on the rate of index bonds.

Step-by-step solution

Step 1. Meaning of Index bonds.

A bond in which payment of interest income on the principal is related to a specific price index, usually the Consumer Price Index (CPI) is an index-linked bond.

Step 2. Reason for government to offer index bonds.

The government would choose to offer indexed bonds even when it gains from inflation because the interest rate is guaranteed on index bonds and the inflation rate has no influence on the rate of index bonds. The index bond investors get protection and encouragement from the interest rates and the government does not have to offer high-interest rates with the high inflation rates.