AN OPTIMAL TEMPORARY LOAN MODEL FOR STATE BORROWERS

Abstract

THE RELATIONSHIP BETWEEN public cash management and interest rates is not well defined. Most of the empirical literature dealing with monetary implications of state borrowing policies relies on national aggregates of borrowing, whether the studies be cross sectional or time series (Morris, Tanzer, and McGouldrick). Often the specifications in these models include variables suggesting that state and local debt is a function of various money market interest rates as well as variables closely related to the purpose of borrowing, e.g., construction needs, contract awards and mandated expenditures. These studies usually conclude that state borrowing is only moderately influenced by cyclical changes in interest rates. In addition, they generally ignore the effects of a state's borrowing on its own interest rate. This study develops a model based on the theory of the transactions demand for cash and incorporates the relation between borrowing and investing by states. The model is applied to a specific type of borrowing by state governments: temporary borrowing for the general fund. It uses as an example temporary borrowing for New York State during the 1960's and early 1970's. In Section I, the model is developed; Section II provides an application of the model to New York State data; and Section III is a discussion of the implications of the results. We develop the arguments in support of a proposal for increasing state revenues by optimal borrowing and lending policies. The proposal is based on the existence of two related factors affecting the management of cash balances in state fiscal operations: (1) the non-synchronization of receipts and expenditures which produce surplus funds at some points in time and deficiencies at others, and (2) the spread between the interest rate for tax-exempt short-term tax anticipation notes and the yield on the short-term assets in which idle balances are invested. We show that state borrowing policies should have objectives beyond simply adjusting to current cash needs.