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The portfolio theory of inflation and policy (in)effectiveness

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  • Bossone, Biagio

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.

Suggested Citation

  • Bossone, Biagio, 2019. "The portfolio theory of inflation and policy (in)effectiveness," Economics - The Open-Access, Open-Assessment E-Journal (2007-2020), Kiel Institute for the World Economy (IfW Kiel), vol. 13, pages 1-25.
    • Handle: RePEc:zbw:ifweej:201933
    DOI: 10.5018/economics-ejournal.ja.2019-33
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    Cited by:

    1. Biagio Bossone, 2021. "Exercising Economic Sovereignty in Today's Global Financial World: The Lessons from John Maynard Keynes," Working Papers PKWP2120, Post Keynesian Economics Society (PKES).
    2. Biagio Bossone, 2020. "Why MMT can’t work: A Keynesian Perspective," Working Papers PKWP2020, Post Keynesian Economics Society (PKES).
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    4. Vukovic, Darko B. & Maiti, Moinak & Frömmel, Michael, 2022. "Inflation and portfolio selection," Finance Research Letters, Elsevier, vol. 50(C).
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    6. Biagio Bossone, 2024. "Keynesian Policy Space in "Globalized" Economies," Working Papers PKWP2405, Post Keynesian Economics Society (PKES).

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    More about this item

    Keywords

    credibility; exchange rate; financial integration; global investor; interest rate; intertemporal budget constraint; money; bonds and assets; pass-through;
    All these keywords.

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • H3 - Public Economics - - Fiscal Policies and Behavior of Economic Agents

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