ABSTRACT
This chapter focuses on how four tools of financial analysis—growth analysis, portfolio analysis, hedging, and consumption smoothing—can help elected officials, budgeters, and scholars anticipate the answers to four basic questions about forecasting uncertain financial futures. The basic questions are: how much can revenues be expected to grow? how much revenue volatility is likely to occur? how much can volatility be reduced without jeopardizing growth expectations? and finally, how long is it safe to wait before acting? It shows how two basic ideas that have dominated modern financial theory-variance and drift-can enhance crystal-ball gazing for budget practitioners and theorists alike. The chapter identifies some of the analytical tools needed to use these concepts—mean-variance analysis, Monte Carlo simulation, optimal control theory, and covariance analysis. These concepts, techniques, and applications are all borrowed from modern financial theory, and they can be applied to a wide array of public sector financial management problems.
