Fiscal policy is examined in the context of a variable price IS-LM model with
a full-employment constraint. Debt-financed fiscal actions are shown to be
destabilizing, regardless of the impact of debt finance on aggregate demand.
The difficulty arises because growth of the capital stock is required to increase
aggregate supply sufficiently to match the increase in demand necessary to
balance the budget. However, debt financing raises the interest rate and
reduces investment. As the deficit persists, further debt issued and higher
interest rates will further dampen investment. Since the necessary increase in
investment is not forthcoming, balanced budget equilibrium is never attained.
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