Introduction

Abstract

The analysis will be conducted within an IS—LM model of a small open economy featuring the dynamics of money wages, private capital, public debt and foreign assets. A macroeconomic shock induces an extended process of adjustment that is characterized by unemployment. This in turn requires a dynamic path of monetary and fiscal policy: As a response to the shock, the central bank continuously adapts the quantity of money so as to keep up full employment all the time. And the government continuously accommodates its purchases of goods and services. Can this be sustained? Or will public and foreign debt tend to explode, thereby driving the stock of capital down to zero?