During recent years, more state and local governments have made provisions in their budgets for establishing and maintaining contingency reserve funds. A recent study by the National Conference of State Legislatures(NCSL) found that over half of all states now have such funds. The basic purpose of these contingency reserve funds, also referred to as “rainy day” funds, is to insulate governmental budgets from unexpected fiscal disruptions brought about by such factors as unanticipated revenue shortfalls and expenditure overruns. What have received less attention, however, are the criteria which governments need to use in deciding whether to establish such contingency reserves in the first place, and if so, how large these reserves should optimally be. This article explores these two issues, using the State of California as an illustrative case s