RATES OF RETURN AND THE SUPPLY OF GOVERNMENT ASSETS

An important issue in macroeconomics has been to determine the effect of an increase in government borrowing. The ''traditional'' response, an increase in the interest rate, has been challenged by the notion of Ricardian equivalence. This paper argues that a positive correlation between debt and interest rates can exist in a model with optimizing rational agents through a portfolio substitution effect in response to changes in the supply of government bonds. A consumption/savings model with government borrowing is developed and the conditions for an increase in debt to increase interest rates are determined.