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Optimal Debt Management with a Stability and Growth Pact

PFM, Vol. 1 No. 1, (2001)

The "Stability and Growth Pact" introduces deficit stabilization as a
new objective of debt management. The interest payments on public debt
may serve as a hedge against the budget consequences of cyclical
downturns and unexpected deflation. The optimal debt composition depends
on the correlations between interest rates, output and inflation. Estimated
correlations for the period 1960-1997 and the implied debt compositions
provide benchmarks for implications regarding the EMU. The paper
explores how relevant correlations between output, inflation and interest
rates may have changed with the shift in the monetary regime and thus how
the debt composition, which stabilizes the deficit, has changed. A longer
maturity structure of conventional debt is optimal if the ECB places a lower
weight on output stabilization than the national monetary authorities and if
EMU member states are hit by asymmetric shocks. Short-term conventional
debt should instead be issued by countries which experience a relatively
higher output and inflation uncertainty and a lower sensitivity of aggregate
demand to interest-rate changes. The optimal share of inflation-indexed
debt is largest in a strict inflation targeting regime; the lower the weight
that the ECB assigns to output stabilization, the more attractive is inflation
indexation for deficit stabilization.

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