45. The government bond markets: size, composition, significance.

A government bond is a bond issued by a national government denominated in the country's own currency. The first ever government bond was issued by the English government in 1693 to raise money to fund a war against France.

A well-functioning government bond market – more pertinently a Treasury securities market – can play a critical role in developing domestic bond markets. It can increase investor confidence in overall bond and financial markets. It can also provide a risk-free benchmark yield curve, which is crucial for revaluating portfolios and pricing corporate bond issues. Banks hold a very large proportion of their assets in government bonds, which mean that stable debt management becomes critical for financial stability. A government debt market does this first by putting in place a basic financial infrastructure including laws, institutions, products, services, repo and derivatives markets, and second by playing a role as an informational benchmark. A single private issuer of securities would never be of sufficient size to generate a complete yield curve, and his securities would not be nominally riskless because only the government has the power to print domestic currency. The government, through the government debt market, can therefore provide a public good to financial markets, but only under two further conditions. First, macroeconomic volatility, especially inflation volatility, must be low so that a nominal yield curve is informative about the real cost of borrowing. And second, the government must issue a sufficient volume of debt.

The government bonds play an important role in the monetary policy too:

When people purchase U.S. bonds, it injects money into the U.S. economy with the goal of economic stimulation and it helps offset the costs of various government projects and expenses. U.S. bond investors are not just U.S. citizens and businesses, but can consist of a wide range of domestic and foreign individuals as well as foreign governments.

Role in Decreasing/Increasing Money Supply

The Federal Reserve Board (the Fed) decreases the economic money supply by selling bonds it already owns. By doing so, the Fed is attempting to decrease upward price pressure, curb inflation and increase the value of the Dollar. In the case of slow economic growth or recession, the Fed buys government bonds to increase the economic money supply. By doing so, the Fed is attempting to increase demand for goods and services, avoid job losses and prevent the economy from slowing even further.

Role in Interest Rates

When the Fed decreases the money supply by selling bond it already owns, it increases interest rates. This increases the amount of money that banks are required to keep on hand to cover their liabilities, called a "reserve requirement." 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 decreases the reserve requirements for banks. This leaves banks with more money to lend to consumers, encouraging borrowing and stimulating economic growth.

Role in Local Economies

State and local governments also issue bonds, called municipal bonds. The proceeds from the sale of these bonds fund statewide and local projects. These projects include 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 by inducing 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.

As of 2009, the size of the worldwide bond market (total debt outstanding) is an estimated $82,2 trillion, of which the size of the outstanding U.S. bond market debt was $31,2 trillion accordingly to BIS (or alternatively $34,2 trillion accordingly to SIFMA – The Security and Financial Markets Association)