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 r
ational 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 incr
ease in debt to increase interest rates are determined.