Optimal Debt Management with a Stability and Growth Pact

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.