Short-Term and Long-Term Interest Rates:

This principle states that government should be in a position to create and redeem the public debts but only at a lower interest costs. The term, structure and the interest rate will have a bearing on debt management.  Evidence shows that short term rates are either close to or above the long-term rates.  However, during the 1930s depression the short-term rates were below the long-term rates and all rates declined.

In order to reduce the cost of war debt during and post World War II, the government tried to keep the rates low.  This could be possible by undertaking borrowings from the commercial banks on a large scale by which the money supply has increased. This policy was continued in the post-war period and which is contrary to the monetary policy followed in 1950s.  At one stage the debate relating to long-term versus short-term issues assumed importance.  But the contention that short term issues would minimize interest costs and so a large part of debt should consist of such instruments has no longer been valid. It cannot also be said that interest cost is minimized by selling those bonds which can be sold at the lowest current interest rates.  Therefore, it is necessary that expectation of rates need to be considered along with current rates.

The implications of the term structure of interest rates for debt management suggest asking whether interest cost is minimized by selling those bonds which can be placed at the lowest cost to maturity.  Possibly the answer is no. Following Musgraves, for example that the Treasury borrows for one year at 5 per cent and for 20 years at 7 per cent. It may not be advisable to take one-year issue because by year end the opportunity to borrow at 7 per cent may be lost if the level of rates has risen.  On the other hand suppose the treasury can borrow for 20 years at 5 per cent and for one year at 7 per cent.  The former choice need not necessarily be preferable as the rates may decline before the 20 years have passed.  Here what is important is the direction in which the Treasury expects the interest rates to change. 

If the Treasury expects the rates to rise, the choice is long-term bonds and if the rates are expected to decline, the choice would be short-term issues.  What one has to observe here is that once interest cost contracted for should have to be carried for the entire period even though rates do fall. Similarly the benefits of a low rate would continue even if the rates do rise.  For example, if the Treasury borrows Rs. 1000 in the market in which a 20 year bond, if selling at par, must carry a coupon rate of 6 ½ per cent.