The portfolio theory of inflation and policy (in)effectiveness

Biagio Bossone

doi:10.5018/economics-ejournal.ja.2019-33

Abstract

Abstract The analysis of open macroeconomies typically assumes (implicitly or explicitly) that resource allocation decisions are taken by domestic agents. The Portfolio Theory of Inflation (PTI) developed in this study assumes that some critical allocation decisions are taken by global investors and investigates how such decisions affect the effectiveness of macroeconomic policy in open and highly financially integrated economies. The PTI adopts a modified version of the portfolio balance approach to exchange rate determination and incorporates optimal intertemporal choices from global investors who allocate resources internationally based, inter alia, on the perceived policy credibility of the national authorities and their policies. The PTI shows that when a country has low credibility and is heavily indebted, investors hold its economy to a tighter intertemporal budget constraint and policies aimed to stimulate output growth do in fact dissipate into currency depreciation and higher inflation, with limited or no impact on output. On the other hand, high credibility creates space for effective and non-inflationary macro policies with limited impact on nominal variables.

Highlights

Is it true that floating exchange rates protect an economy from the consequences of “sudden stops” in capital flows, and grant its policymakers greater flexibility in both managing demand and sustaining public debt? Or that a country enjoys more fiscal space if it denominates its debt in its own currency? And even more so, if its debt is held by its residents? Should countries that are part of a fixed exchange rate or currency union arrangement exit the arrangement in the expectation that it would give them more freeway to raise output and employment?As is usual with most questions in the realm of economics, the answer to the above ones is, «it depends...»
I realized that financial integration does not need to be “full” for the above implications to hold for any given country, and that a “high” degree of integration would be sufficient to that extent, where “high” means that the public liabilities of the country are traded in the international financial markets and their prices are determined by investors who i) manage their portfolios taking a global perspective on local investment opportunities
While the analysis of macro policy effectiveness typically assumes implicitly or explicitly that resource allocation decisions are taken by domestic agents, the Portfolio Theory of Inflation (PTI) assumes that, when countries are integrated in the global real and financial markets, critical resource allocation decisions are taken by international investors acting on a different perspective, and uses this assumption to evaluate how these decisions affect macro policy effectiveness at the country level

Summary

Introduction

Is it true that floating exchange rates protect an economy from the consequences of “sudden stops” in capital flows, and grant its policymakers greater flexibility in both managing demand and sustaining public debt? Or that a country enjoys more fiscal space if it denominates its debt in its own currency? And even more so, if its debt is held by its residents (as opposed to nonresidents)? Should countries that are part of a fixed exchange rate or currency union arrangement exit the arrangement in the expectation that it would give them more freeway to raise output and employment?. If the policy authorities of the above poorly credible and highly indebted economy operating under a floating exchange rate regime were to use the macro levers actively, they would cause capital to flee the country, the nominal exchange rate to depreciate, and domestic inflation to rise. They would be forced to reverse their course of action and manage the economy to what they would have done, had they committed to maintaining a fixed exchange rate rule to start with.

Relations with the literature

The portfolio theory of inflation

Why is a new theory of inflation needed?

Conclusion