On Fiscal Policy and Macroeconomic Stability

Abstract

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.