OPTIMAL FUNDING RULES

The operation of automatic fiscal stabilisers may prevent interest rat es from falling during times of recession, while they may lower intere st rates during recovery, thereby exacerbating the private sector busi ness cycle. We demonstrate that the government funding authority may d evise rules for debt issuance which minimise the variance of the gover nment's overall funding requirement. This is done by switching issuanc e between different debt instruments in such a way that interest and r edemption payments counteract the cycle in the underlying funding requ irement, thereby removing any autocorrelation in the net funding requi rement. We illustrate the application of such a funding rule to the bo rrowing requirement of the United Kingdom government: this has the eff ect of smoothing out the borrowing requirement over the business cycle .