"Who will buy the bonds?
"The government needs to sell bonds to finance an expansionary fiscal policy. But who will buy the bonds? What happens if nobody wants to?"
What we ought be be concerned about is the exact opposite. The fiscal policy will be more likely to succeed of people do not want to buy the bonds.
Suppose, just as an example, that the proposed fiscal policy is a bond-financed tax cut, holding government expenditure constant. And suppose, again just as an example, that Ricardian Equivalence holds exactly. In this example, there's a simple answer to the question: "who will buy the bonds?". Each person receiving a $100 tax cut (or transfer) will want to save the whole of that $100, and buy an extra $100 of bonds. The extra supply of bonds creates its own demand. And yet this example is precisely the case where fiscal policy will fail to stimulate aggregate demand.
An increased demand for bonds means extra savings, and we don't want that to happen. We don't want an increased supply of government bonds to be met with an increased demand for government bonds. We want to create an excess supply of government bonds at existing levels of interest rates, prices, and incomes. We want to create a disequilibrium in the bond market, that will force interest rates, prices, and incomes to change. We want to create a disequilibrium in the bond market that will spillover into a disequilibrium in the market for newly produced goods.
Let's take what is conceptually the simplest example: the government prints bonds and gives them to people. (This is equivalent to helicopter bonds or a bond-financed tax cut). If people just hold the extra bonds, that is the end of the story. Nothing else happens. We hope that people will want to get rid of the bonds. We hope that the supply of bonds does not create its own demand.
We want people to try to get rid of the bonds, by trying to sell them, and trying to buy goods.
Bonds are not a medium of exchange, but money is. People cannot directly buy goods with bonds. If an excess supply of bonds is to translate into an excess demand for goods, it must first create an excess supply of money. There are two ways this could happen.
First, the excess supply of bonds could push down bond prices, which means push up interest rates on bonds. And the higher interest rates could cause a fall in the demand to hold money, creating an excess supply of money, and an excess demand for goods.
Secondly, the Central bank might buy the excess supply of bonds, in order to prevent the rise in interest rates. When it buys bonds it sells money. That creates the excess supply of money, and an excess demand for goods.
Now let's consider a bond-financed increase in government spending on goods. As a first step, the government needs to sell $100 bonds for $100 money; in the second step it uses the $100 money to buy $100 worth of goods. The net result is that the private sector holds the same amount of money, but $100 more bonds. If the private sector was willing, at unchanged interest rates, prices, and incomes, to hold the same amount of money and $100 more bonds, that would mean the fiscal policy would fail to stimulate demand. Because the only way the private sector could hold an extra $100 of bonds is if it saved an extra $100 of its income by reducing its consumption by $100. But if a $100 increase in government demand for goods lead to a $100 decline in consumption demand, the net effect on aggregate demand would be precisely $0.
Again, what we should be scared of is not that people won't want to buy the bonds, but that they will want to buy the bonds (at existing interest rates, prices and incomes). We want to create a disequilibrium on the bond market. We want fiscal policy to force interest rates, prices, and ultimately incomes to change.
In general, we should be more worried that people will want to buy and hold an extra supply of bonds than that they won't want to. Ideally, for fiscal policy to be most powerful, the private sector would refuse point blank to hold any more government bonds, at any rate of interest, price level, or level of income. In this case the central bank would be forced to buy all the bonds, so government expenditure would be money-financed. And if people refused point blank to hold any increased stock of money as well, we would be incredibly lucky. Because the extra $100 stock of money would create a $100 excess supply of money, which people would try to spend out of existence, again and again, and the hot potato would pass from one hand to another indefinitely, making the fiscal multiplier infinite.
But I think there is one important exception: if the fiscal authority in question does not have its own money and central bank, things are different. If we are talking about fiscal policy in a Canadian province, or a Eurozone country, we might be worried the other way. I will deal with that question in a later post.