Final answer:
Discussing whether governments should issue price-level indexed debt considers indexed bonds' inflation protection and moral hazard with domestic currency fixed debts, linking to budget deficits, interest rates, and economic impacts.
Step-by-step explanation:
Whether all governments should issue debt that is indexed to their domestic price level is a complex question that takes into account various economic factors. Indexed bonds promise to pay a real rate of interest above whatever inflation rate occurs, thereby offering protection to investors against inflation risk. However, there is a potential moral hazard problem when government debt is fixed in units of domestic currency because officials may have an incentive to allow inflation to rise to reduce the real value of the debt, leading to negative real interest rates and undermining confidence in the government's fiscal management.
As populations age and the demand for government services increases, the consequent rise in government deficits may require borrowing that diverts resources from vital investments in human and physical capital. If interest rates rise, the government would be under pressure to reduce budget deficits, either through spending cuts or tax increases, which could have a negative impact on economic growth by lowering aggregate demand. Thus, indexed bonds can provide security for investors, such as retirees, seeking to protect their investments against inflation, while also serving as a check on governments considering inflationary debt-reduction strategies.