This article revisits the Portfolio Theory of Inflation (PTI) proposed in my original work published earlier (Bossone, B. (2019, 4 June). The portfolio theory of inflation and policy (in)effectiveness. Economics Journal, 1–25. Article No. 2019-33.), with a view to further articulate its findings and implications. The article adds to the micro- and macro-foundations of the PTI model of the economy, framing the portfolio choices of global investors more rigorously, providing richer analysis of their macroeconomic effects, and in the process also correcting errors contained in the original PTI formulation. The article explores additional dimensions of how capital allocation choices by global investors interact with government macro-policies, and further studies how such choices shape the space available to country authorities for active macro-policies. The article further evaluates the results from the revisited model on the dynamics of exchange rate, inflation, and output following macro-policy shocks, and appraises the implications of the PTI for macro-policy effectiveness when due consideration is given to stock variables, as opposed to flow variables only, in the context of highly internationally financially integrated economies. Finally, the article considers what is new about the PTI as a theory of inflation and clarifies some of its possible misinterpretations.
Despite financial globalization, the models still currently used to analyze the effects of macroeconomic policies do not recognize the power of global investors to determine the prices at which public sector liabilities (money and debt) are traded on the markets and do not consider how such power affects the effectiveness of the policies. This is true for conventional orthodox (mainstream) modeling, in which the key actors (families, businesses, and institutions) are represented by local agents who make optimal allocative choices based on a menu of possible options, and it is equally true for heterodox approaches (take Modern Money Theory, MMT, as an extreme example) in which governments can issue all the money needed to finance public spending in support of full employment, counting on the fact that there will always be sufficient demand for all the money issued. In both cases, local agents are believed to be sovereign and able to make optimal choices.
In fact, in highly financially integrated (globalized) economies, especially where wealth is largely concentrated and financial investments are managed by global operators, the value of public sector liabilities, and the space available for government policy (the “policy space”), are determined by the expectations and trading activity of global investors.
Global investors must therefore be brought into center stage of macro-analysis if one wants to understand how policies work in the global financial context and gauge their impact on the real economy. This has become even more compelling with the growing importance of the international bond market as a major source of external finance for many countries and the significant increase in debt issuance following the long period of low interest rates.
This article revisits the Portfolio Theory of Inflation (PTI) as originally proposed in my previous work (Bossone, 2019), and recently revised (Bossone, 2021) with a view to further articulate its findings and implications. The article adds to the micro- and macro-foundations of the PTI model of the economy, framing the portfolio choices of global investors more rigorously, providing richer analysis of their effects on inflation and output, and in the process also correcting errors contained in the original formulation (as detailed below). The article explores additional dimensions of how capital allocations by global investors interact with government macro-policies. It further studies how country credibility enters the capital allocation choice process of global investors and how global investor choices shape the space available to country policy making, determining the extent to which the effect of macro-policies dissipates into exchange rate depreciation and higher inflation. The article also pulls together reflections and considerations that I have variously discussed in other related works (Bossone, 2020a,b).
Notice that since the literature relevant to the PTI is reviewed at length in Bossone (2019), and no additional references are considered in this article, the review of the relevant literature will not be replicated here and interested readers should be referred to that work.
Section 2 discusses the role of global investors in today’s internationally highly financially integrated economies, and how this role shapes the policy space available to countries. Section 3 integrates the micro side of the PTI model of the economy, using asset utility analysis, and derives optimal inter-temporal and intra-temporal rules for portfolio allocations by the representative global investor. Section 4 evaluates the new results from the revisited model on the dynamics of exchange rate, inflation, and output following macro-policy shocks. Section 5 appraises the implications of the PTI. Section 6 considers what is new about the PTI as a theory of inflation and clarifies some possible misinterpretations. Section 7 concludes the article.
2 Global Investors: Why are They so Relevant?
Global investors act as “marginal” investors, and because of their size, interconnectedness, and comparative advantage, they exercise the largest influence on the pricing of market trades. While substantial portion of funds are held by local investors and are invested abroad (in the absence of capital account restrictions), local investors act as price takers in the international markets for financial assets, where prices are set at the margin by global investors. In addition, as local investors typically lack the resources and expertise, their investments often go through the global investors or through local intermediaries which further intermediate their investments through global investors.
Global investors are not necessarily foreign agents; they can be resident persons, domestic subsidiaries of foreign entities, foreign subjects operating in a country through domestic correspondent agents, or dealers. Global investors mobilize far larger resources and process far greater information than smaller agents operating locally. They also trade at much lower costs than local agents and, unlike local agents, their choices are not affected by “home bias” – even when they reside in (or operate from) a country, they use at most only a modest fraction of their managed wealth to finance local consumption. Global investors do not optimize consumption but seek to maximize utility from financial wealth through wealth management. They are not interested in the stability of the countries where they invest, if not to protect the value of their investment, and do not bear the costs of economic stabilization measure when these are undertaken. If anything, they stand ready to rush for the exit from country investments (shifting capital elsewhere) when the country’s stability is perceived to be at risk.
Local agents demand domestic currency to finance local transactions and tax payments, yet their demand might not be enough to prevent the currency from depreciating, as the value of their money is ultimately set at the margin by global investors, and while local agents operating in relatively closed, segmented, or captive financial markets must accept and hold public debt issues at convenient terms for the issuing government, global investors operating in internationally integrated financial markets are much more risk-sensitive and set prices accordingly, at less favorable terms for the issuing government and under exit threats that condition debt issuances. Importantly, in such contexts, global investors can move financial capital across markets and countries in real time and at negligible transaction costs.
Under conditions of high uncertainty, the price of a country’s public sector liabilities that global investors consider to be less safe than others declines, and if global investors deem the credibility of a country to be weak or weakening, they act in such a way as to cause the country’s public sector liabilities to lose value if their supply grows at a pace that they reckon to be in excess of what would keep their value stable.
2.1 Government Debt as Claim on Real Resources
Although debt contracts are typically written in nominal terms, they are purchased by investors because of their being claims on real resources. Those who invest in debt contracts intend to recover the full real value of their investment plus interest. Contracts expressed in domestic currency should at least earn the same (net of risk) returns as same contracts expressed in foreign reference currencies, typically, high-hierarchy – reserve – currencies, which are the ultimate claims on world real resources and thus serve as benchmarks. Debt repayments in currencies that depreciate vis-à-vis their benchmarks, and whose depreciation is not adequately compensated by extra returns, do not constitute default legally but are economically equivalent to it.
Should this not be the case, any government could always snatch a “free lunch” by borrowing in its domestic currency, since it can print it in unlimited amounts. This “free lunch” would be a rent extracted by government from lenders. Government can extract rents when lenders are small, uninformed, and with limited investment management capacity, or when they operate in segmented or captive capital markets with limited alternative investment opportunities. On the other hand, a government can no longer extract rents if its economy is globalized and its liabilities trade in the international financial markets. Here global investors assess the government’s debt repayment capacity (in real resource terms) and set prices for its liabilities that reflect that capacity, which is obviously the same whether the contracts are written in domestic or foreign currencies. In all cases, the global investors seek to protect their assets from the risk of not being repaid in real terms, the latter being evaluated with reference to a reserve currency taken as benchmark.
2.2 Money and Monetary Sovereignty
While governments (with monetary sovereignty) may in principle print infinite amounts of domestic currency, this does not alter ex ante the (real) losses that the investors may incur on contracts that differ only for their currencies of denomination: contracts should be expected to be written so that subscribers are indifferent between different currencies.
Losses are still possible ex post, but they would feed back on the terms and conditions of future contracts, which would then build in extra protection for the investors. In all cases, the debtor would be the same whatever currency were used for contract denomination, and the same would be the debtor’s capacity to repay its debt with real resources. Moreover, a lower credibility of the issuing government would imply a higher risk of currency depreciation, and investors would demand a higher interest rate premium for being induced to purchase and hold government liabilities expressed in that currency.
Therefore, no government is truly sovereign in a globalized world, and all governments are subject to an intertemporal budget constraint (IBC) – although governments (and their respective countries and national economies) differ from each other and not all government IBCs are equally binding, as discussed next.
2.3 The Inexorableness of government IBC
The IBC requires a government to commit intertemporally to generating the real resources needed to fulfil their financial obligations to investors. From the latter’s standpoint, a government issuing debt liabilities must be regarded as capable to return the full real value of its future debt obligations plus interest. The IBC must hold identically irrespective of the currency of denomination of the liabilities, since otherwise the investors would arbitrage away from those liabilities that do not earn at least the same (net of risk) return as the benchmarks.
It is often argued that governments enjoying monetary sovereignty do not face an IBC, since they can always print all the money they need to pay for their obligations. In fact, global investors are guided by what they perceive to be the credibility of the issuing governments. Anticipations of an undisciplined fiscal and monetary policy conducted by a government would lead global investors to bid down the value of its money, steering the markets to a point where the demand for the money (and the assets denominated in that money) would shrivel, thereby affecting the government’s IBC. Global investors can just walk (rapidly and costlessly) away from country investments, if so needed, with no commitment to the country at stake and no purpose to continue to operate in it (unlike local agents). In globalized economies, it is thus not the case that all the money printed is demanded at an unchanged price.
Thus, every government (even if it issues its own currency) faces an IBC whose elasticity is endogenous to global investor decisions. The concept of “elasticity,” which reflects the amplitude within which the constrain may expand without compromising financial stability, captures two complementary aspects: first, given the endogeneity of the IBC to global investor decisions, different levels of credibility attributed to a given country determine different constraints on government policy action; second, countries with stronger credibility benefit from more flexible IBCs, in the sense that their government enjoys a less stringent constraint (for instance, by being allowed by the markets to run larger deficits without being penalized with lower asset price valuations), while tighter constraints would bind countries with weaker credibility. , 
3 The Economy’s Model
The open-economy model developed originally for the PTI is here reported in an improved formulation. It still consists of two sides – the macro and micro side – that are inter-linked by a representative global investor, whose capital allocation choices are driven by country credibility perceptions. The two sides of the economy are considered in turn.
3.1 The Macro Side
The PTI model’s macro section consists of two open and highly financially integrated country economies D and F, where F is relatively large vis-à-vis D and acts as the price setter in the international markets for goods and services, and D is the price taker. The issuance of government debt bonds in country j, where , and their market values are tied to the country government’s IBC.
Equation (1) is the IBC of country j’s government and requires that the current market value of government bonds B equal the present discounted value of the future expected streams of government primary surpluses and monetary financings by the central bank (CB) (if any), based on information set available to the investors at time t. In the equation, is the time discount rate; P is the world price deflator used by global investors to gauge at any time the real value of their wealth; E is the expectations operator; B is the number of nominal (interest-bearing) bonds issued by the government at a contractual value that is equal to 1 unit of money, and their market value is expressed as a ratio to the bond’s contractual value. All else being equal, this ratio changes directly with credibility factor a time-varying factor, conditional on information set , which acts as a scale factor that corrects the value of the IBC in the perception of the markets, based on the credibility that investors attribute to country j’s policy. This factor is key in the PTI context and is discussed in Appendix 1: it reflects the global investor views of a country’s credibility and recognizes country credibility as a core aspect of international capital allocation in global financial markets; it plays a special role in linking the macro and micro dimensions of such allocations; and it is a realistic feature, since establishing ex ante the credibility of a government to determine its debt repayment capacity is an ordinary practice of international finance.
According to equation (2), total public debt, which equals the stock of government bonds inherited from the previous period plus any current new bond issuance, is held by representative global investor H and the CB of the issuing country.
World price index P in equation (3) is used by global investors to calculate the real value of relevant financial variables and is calculated as the weighted geometric mean value of the general price level attained in individual countries, and , with weights proxying the relative size of each country’s investment within the global investor’s portfolio, and taken as exogenous. Country D’s price level is determined from the cost side by foreign price level via the nominal exchange rate e, and the exchange rate pass-through (ERPT) factor , and from the demand side by the output gap (equation (4)), each with weight characterized by the openness of the economy to foreign trade. According to equation (5), ERPT factor raises (structurally) with the degree of openness of the economy, , and declines with country credibility as higher credibility anchors inflation expectations and attenuates the impact on inflation caused by the ERPT effect.
Equation (6) reflects the CB’s decision to purchase or sell government bonds (and thus to issue money M or to withdraw it from circulation) following the Taylor rule of equation (7): the higher the target interest rate vis-à-vis the neutral level , the larger the amount of bonds purchased and, thus, the larger the amount of money withdrawn from the economy.
Reduced form of equation (8) posits the real output gap (i.e., the difference between actual and potential output) to change (a) negatively with the deviation of current interest rate from its neutral level, (b) positively with the real exchange rate (assuming Marshall-Lerner condition), and (c) positively with the fiscal deficit (assuming away full Ricardian equivalence), and assumes potential output to grow at gross rate . Debt-financed fiscal deficits (under a non-accommodative monetary policy) also affect the real output gap negatively due to their impact on the interest rate, as captured under relation (a) above. It is assumed, however, that the net effect of fiscal deficits on output is generally positive. Finally, equation (9) is the debt-financed fiscal deficit expressed in real terms where S is the nominal primary surplus.
3.2 The Micro Side
The PTI model’s micro section draws from the conventional portfolio balance approach to the exchange rate determination, reframed in the context of optimal intertemporal allocation choices by a representative global investor acting in internationally integrated financial markets and perceived by the representative “marginal” global investor (Section 3.1). This agent maximizes financial wealth intertemporally (in utility terms), with a view to consume it all at “the end of time” (if she is infinitely lives) or to pass it on to future global investors (if she is finitely lives), who will behave similarly across the infinite time horizon, as if they all worked for a company with the same company purpose. Global investors, thus, act collectively as an intertemporal class of agents, who treat the assets in their portfolios as “vehicles” to the utility associated with the future streams of real resources to which they give access (Bossone, 2014). These agents may act in their own interest and/or they may intermediate financial resources intertemporally from surplus agents to deficit agents demanding resources for investment or consumption-smoothing purposes.
Formally, representative global investor H maximizes the intertemporal utility generated through wealth portfolio W:
and transversality condition
In equation (10), is a standard strictly quasi concave, time-separable, and well-behaved utility function; is the net additional investment or divestment taking place through global investor H, where net divestments correspond to consumption decisions taken by the agents who had previously invested in the portfolio of global investor H; and R is the real gross rate of return on any asset Q (here money M or bonds B), which includes the risk of loss and is calculated as , where is the nominal own rate of return on asset Q; p Q is the rate of change of asset Q price, ; p is the rate of world price inflation, which also reflects the exchange rate variation between the currency of denomination of asset Q and the currency chosen as benchmark; and is the risk of loss from default on asset Q, as perceived by global investors, which reflects the credibility that investors attribute to the issuer of the asset (i.e., it increases as credibility factor declines), and while any functional form could be assumed to link the two variables, the simplest possible form used here for convenience and without loss of generality is , with maximum loss (i.e., ) for and no loss (i.e., ) for .
Equation (11) is the investor’s instantaneous budget constraint, where only wealth inherited from the previous period and any new net investment can be allocated to domestic and foreign assets; notice that the term also incorporates any losses that may have materialized on past investments. According to condition (12), the investor may hold non-negative quantities of each asset and net changes in the investor’s wealth portfolio can be positive (as a result of investments), negative (as a result of divestments or losses from defaults), or zero (as a result of offsetting investments and divestments or of no investment and divestment activities). Equation (13) requires that the aggregate demand of government bonds by investors and the CB equal supply under the impending government IBC; this determines the policy space available to the CB: given an expansionary monetary policy stance, if global investors deem it consistent with the stability of the external value of the debt they hold (based on the world price deflator P, defined in equation (3)), they will allow for the policy to run its course, thus making it effective; otherwise, they will penalize it by bidding down the price of the debt and neutralizing the policy impact on real output (Section 4.1). Finally, equation (14) is the transversality condition consistent with the function of “global investor” discussed at the outset of this section.
In this model, where assets are vehicles to future consumption, each characterized by its own “speed” (readiness and cost to be liquidated) and “power” (capacity to store value and to accumulate wealth over time), the utility of any asset Q, as shown in Appendix 2, is given by
where is the probability of Q’s holder having to convert the asset into consumption at the next date t + 1, and is the variable liquidation cost of asset Q.
4 Nominal and Real Effects of Macro-Policies
where is the vector of the real returns (net of the risk of losses) on the assets held in portfolio , leading to the Euler equation:
with . Given the optimal time path of managed wealth W, as determined by equation (17), the optimal portfolio composition of global investor H at each date of the relevant time horizon must reflect optimal intra-date allocations of the wealth portfolio across the range of available assets. These allocations are derived by fulfilling the following two first order conditions:
which requires equating the marginal utilities of M and B holdings, each weighted with its own price, and
which requires equalizing all rates of return on assets in real terms and net of default risk at each date and intertemporally. For completion, since the global investor acts on behalf of his client wealth holders, optimality requires that the periodical divestments from its portfolio to finance consumption activities (discussed earlier) generate, at the margin, the same utility that is generated by the assets held or acquired by the global investor.
Solving the model simultaneously for all demand and supply relations, under well-behaved investor preferences and optimal fiscal and monetary policies (that is, policies that are consistent with the government IBC), as well as with complete ERPT, and a given world price deflator P, optimal portfolio allocations attain at equilibrium asset prices and , neutral interest rates and , and nominal exchange rate consistent with a balanced (zero) real output gap. Critical to the existence of such general equilibrium position of the economy is that the stocks of money and debt required to ensure zero output gap are consistent with the government IBC. This reveals the relevance of the credibility factor and its central role in linking the macro and micro sides of economies where capital resource allocations are determined by global investors. For simplicity, but without loss of generality, assume utility to be . Then, dropping subscript H and solving equation (18) for the equilibrium nominal exchange rate at date t, we obtain
This solution allows for determining and evaluating the nominal and real effects of macro-policy shocks.
4.1 Nominal Effects
Equation (21) shows that for a given demand for (domestic and foreign) money and bonds, the nominal exchange rate of domestic vs foreign assets, all else being equal, varies positively (i.e., depreciates) with:
The growth of domestic (relative to foreign) supply of money bonds;
The growth of domestic (relative to foreign) bond prices; and
The risk of losses on domestic (relative to foreign) bonds as proxied by the credibility gap between the issuing countries.
Importantly, any persistent difference in country credibility has a persistent, and hence cumulative, effect on the exchange rate.
Log-linearizing and replacing equations (6), (8), (9), and (21) into the log-linearized form of equation (4), assuming a fully accommodating monetary policy stance (i.e., , from equation (7)) and solving for domestic inflation, yield
with , where , , , and the ERPT term has negative sign, except when the pass-through is complete (equation (5)) and, therefore, . Equation (22) shows that, all else being equal, domestic inflation varies:
Positively with changes in the domestic monetary and financial stocks relative to foreign benchmarks;
Positively with changes in domestic (relative to foreign) bond prices;
Negatively with country credibility;
Positively with foreign inflation; and
Positively with fiscal policy shocks.
Notice that due to the persistent effect of credibility on the exchange rate, noted above, a lower level of country credibility (relative to a benchmark country) puts permanent pressure on inflation.
Global investor choices and the country’s macro-policies interact with each other, since changes in the budget and budget financing modalities bear changes in the stocks of M and B and trigger allocative responses by global investors, based on country credibility. Such responses may change as new information arrives.
4.2 Real Effects
Regarding the effects of monetary and fiscal policy shocks on real output (equations (6) and (9)), the analysis in Bossone (2019) remains valid despite the model revision, as can be seen by log-linearizing equation (8) and solving for output:
Equation (23) incorporates, inter alia, equations (21) and (22) and is dual to them: it shows that, all else being equal, policy shocks that do not dissipate into higher inflation do add to real output (and vice versa), the dissipation effect being a consequence of the value of credibility factor , as already discussed: lower (higher) credibility makes macro-policies less (more) effective. Also, there is a critical level of credibility factor at which there is no real output effect, since currency depreciation and inflation dynamics are such as to induce an interest rate adjustment, which depresses output through the term. This follows from the market pressure on the value of government debt (equation (1)) and from the concomitant action of the CB, which raises the target interest rate consistent with the Taylor rule (equation (7)). At high rates of depreciation and inflation, it is also likely that the weight attributed by the CB to the inflation objective (that is, the sensitivity of the CB to mitigate inflation as a policy objective) moves closer to 1, at the expense of the output gap weight, , which becomes relatively less important. Appendix 3 describes how policy shocks reverberate through the economy under the PTI model.
The term of equation (22), which is implicit in equation (23), suggests two considerations. First, the higher is the sensitivity of aggregate demand to the domestic price level through the real exchange rate (equation (8)), the larger is its dampening effect on the inflation response to shocks from the variable on the RHS of equation (22), and hence the larger is the real output effect (equation (23)), and vice versa. Second, even with no dampening effect, due to, say, a large negative output gap, such that , demand policy shocks would still impact inflation through capital re-allocations by global investors and their effect on the exchange rate: with complete ERPT (i.e., the occurrence of positive and fully accommodated fiscal shocks would cause the nominal exchange rate to depreciate and to feed fully into domestic inflation, even at less than full employment output, and would thus weaken the real effect of the shock. Obviously, a complete ERPT is a limit case since, in general, economies (especially the larger ones) feature lower ERPT effects and, as recalled earlier, more credible countries tend to feature lower ERPT effects. Thus, in the case of similar policy shocks occurring in a large, highly credible reserve-issuing country, the impact on domestic inflation would be attenuated, while the impact on output would be amplified.
In sum, based on equation (20), expansionary policies that weaken the credibility of a country (say, because they threaten the future sustainability of public sector liabilities) devalue the currency and increase inflation (equation (22)), with the latter eventually offsetting the positive effect of depreciation on real output, or worse, if interest rates adjust to a point where they lower real output (equation (23)), and equation (1) tells whether the impact of weaker credibility on the IBC affects the sustainability of public sector liabilities, and thus requires policy reversals. It follows that the same policy can score from being fully effective to being fully ineffective (in terms of output), depending on credibility as perceived by global investors and on the impact of the policy program on credibility expected by global investors. If ineffective, the policy effects will eventually dissipate through currency depreciation and higher inflation.
Thus, global investors determine the relative (in)effectiveness of macro policies at the country level: The weaker the credibility of the country, the narrower its policy space (as determined by the global investors) and the greater the contraction of such space due to policy choices that global investors believe will further weaken the country’s credibility .
Consider now the exchange rate. According to the PTI, with high international financial integration and global investors playing the role of asset price setters, a persistently growing stock of public sector liabilities (money and debt) is sooner or later expected to exceed its optimal level, even if the economy is at less than full employment. This happens sooner, rather than later, in countries suffering from relatively weaker policy credibility, where the demand for assets denominated in domestic currency is at any time dominated by the demand for assets denominated in foreign currencies. Here, the higher is the expected growth of money and/or public debt, the lower tends to be the credibility attributed by the markets to the national policy authorities.
All else being equal, the growth of excess liabilities is more likely to happen in countries with lower credibility, where the growth of money supply and debt would not as easily be absorbed by an increasing demand, for the reasons discussed above. With expectations incorporated in the model, anticipations of future nominal exchange rate devaluation do accelerate actual devaluation; and, with rational expectations, anticipations of currency devaluation fulfill themselves instantaneously.
Finally, as noted, the model predicts the nominal exchange rate to depreciate even at less than full employment output, in countries suffering from weak credibility. Depreciation would be driven by the expected growth of public sector liabilities and would be de-linked from their impact on inflation (since the negative output gap makes the economy’s real resource constraint unbinding). Thus, unlike in monetary theories of the exchange rate, inflation would follow (not cause) exchange rate depreciation (due to ERPT effect) and would be independent of resource employment levels.
5 Implications of the PTI
When the stocks of central bank money or public debts grow, somebody must hold them willingly for their value to be stable over time. If money or debt are issued by a highly credible country – especially if the country happens to be the issuer of an international reserve currency – the public generally wants to hold them, markets make the government’s IBC elastic, and the price of the debt or money stock is not much perturbed, if at all. Conversely, when money or debt are issued by a poorly credible country, the public might not necessarily want to hold them, markets make the government’s IBC more rigid, and the relative price of the stocks declines.
Now, while a temporary increase in both money and debt could be effectively used as a stopgap measure even in poorly credible countries suffering from recessions (i.e., the helicopter money case discussed earlier), a permanent increase in the level of debt – such as to finance state deficit spending on an ongoing basis in an attempt to keep the economy’s output at full employment – would sooner or later affect its value: especially under high international financial integration, the perspective of an indefinite or unorderly growth (and accumulation) of the money and debt stocks would induce portfolio re-compositions away from those stocks, depress their prices, and lead the economy away from full employment. This is a critique to all theories that do not pay attention to stock variables, as opposed to flow variables, especially in the context of highly financialized economies.
Consistent with this critique, the PTI looks deeper into the inflation generation process. To the extent that (i) government runs permanent deficits and (ii) the money created by government is not loaned out, so that there is no loan repayments and hence no reflux and equivalent destruction of the money originally created, there is permanent net addition to the stock of money supply, which somebody in the economy must absorb for the (internal and external) value of money to be stable. With the stock of (zero-interest earning) money expected to be growing indefinitely, there will be a point where people will start moving out of this money and into alternative assets (including foreign assets). Depending on the level and dynamics of the money stock and the credibility of the issuing country, this process could be gradual and orderly, with inflation (including of asset prices) and currency devaluation creeping in only slowly, or it could be disorderly and abrupt, thereby engendering runs on the currency. Else, the process could start gradually, accelerate, and spiral off thereafter.
No economy is immune from the “stock” narrative just told, although highly credible countries and especially countries issuing international reserve currencies enjoy much greater policy space than less credible countries: the IBC of the former countries is much more elastic (or so it is rendered by the financial markets), and thus the critical point beyond which these countries would start confronting unsustainability issues lies much far ahead than poorly credible countries (assuming same initial conditions).
The IBC elasticity depends not only on domestic circumstances, but on global developments as well. For instance, in the case of non-idiosyncratic shocks that were to hit the global economy at large, the world demand for assets denominated in international reserve currencies would increase independently of the domestic economic conditions of the reserve currency issuing countries. Such higher demand would determine an even more elastic IBC for these countries and would grant them still larger policy space than under normal circumstances, the opposite holding for less credible countries.
Not only the PTI emphasizes the critical role of public liabilities at the core of resource allocation at country level; the theory provides a rationale to understand how national public liabilities are influenced by global factors in the context of high international financial integration. Said differently, the factors influencing the value of the public liabilities of a country cannot be gauged outside of a global perspective: the PTI does incorporate this perspective into the analysis.
6 Why a New Theory of Inflation: Key Aspects of the PTI
Prevailing macroeconomic theories have been unsuccessful at explaining inflation in contemporary economies. Old Monetarism as well as the New Classical school have proven unable to account for how the massive and persistent money injections that were engineered in advanced economies during the Great Recession, and after, have largely failed to rekindle inflation. Similarly, New Keynesianism has been unable to explain the very slow motion of low-interest rate policies to deliver on the inflation targets promised by central banks (Palley, 2019), and its policy prescriptions have been caught in flagrant contradiction with its inherent theoretical Neo-Fisherian structure (Cochrane, 2017).
More recently, the Fiscal Theory of the Price Level (FTPL) has re-asserted itself as a theory to explain the general price level. This is determined by government debt and fiscal policy alone (while monetary policy plays at best an indirect role) as the value required to ensure that the real contractual value of the outstanding stock of nominal (non-monetary) public debt is always equal to the present discounted value of the current and future real primary surpluses and monetary financings of the state budget. Upon rigorous analysis, however, the FTPL has been shown to be internally inconsistent.
What the above theories neglect is how policy effectiveness may change and affect inflation in response to the investors’ diverse attitude toward different countries in a world of highly financially integrated economies. Where credibility is low, the space available for using active demand management policies is limited and the most likely result of such policies is currency depreciation and inflation, with limited or no gains on the real variables of interest (output and resource employment). There is, therefore, a need for a theory that can explain the ineffectiveness of macroeconomic policies and their inflationary consequences, considering today’s global financial context. The PTI offers an explanation based on four features that make it especially fit as a theory of inflation:
No mechanical dynamics. The first feature is that, according to the PTI, there is nothing mechanical about the transmission channel running from government liabilities (money and/or public debt) to inflation dynamics. The transmission rests fundamentally on the role of financial market expectations, perceptions, and conventional beliefs – as revealed by global investors through their portfolio choices – regarding the policy credibility of a country and the future sustainability of its liabilities. To illustrate the point through an example, a country that would expand its public liabilities to finance new output and employment, all else being equal, would be successful in its attempt (and thus ending up with higher output at low inflation) or unsuccessful (thus ending up with higher inflation and limited or no change in the real variables), depending on how the credibility of the country’s authorities and policy institutions is perceived by the market. Whereas the country’s growing liabilities would be deemed to be intertemporally sustainable in a highly credible country, they would be regarded as not being sustainable in a poorly credible one, thus leading investors to very different portfolio allocation choices in each case. According to the PTI, in either event, the market is central in determining the elasticity of the country’s IBC, and while investors may be assumed to act rationally (grounding their portfolio choices on the best knowledge available), the explanatory power of the theory does not require them to be necessarily right in their judgments – the theory simply predicts that whatever investors decide does ultimately determine the outcome of the country’s policies.
The role of exchange rate as an asset price. The second feature is that, according to the PTI, the effect of public liabilities on inflation is not direct but is mediated by the exchange rate as an asset price. Investor portfolio choices impact, first, the exchange rate of the domestic currency as a relative price of the assets that are traded internationally and influence domestic inflation once the changes in the exchange rate are transmitted to domestic prices via the passed-through and relative price adjustment mechanisms. Note that in the PTI setup, the pass-through effect, too, is affected by credibility and the related anchoring of inflation expectations, as supported by evidence. In the PTI, therefore, the financial and trade sectors, both domestic and external, interact strongly with each other, reflecting the degree of integration of the economies into the global (real and financial) markets and placing (perceived) credibility at the core of signal transmission and resource allocation. The different speeds at which financial and trade markets process the information are critical for the transmission of the price signals from financial assets to goods and services and back into the real value of the assets. As the model above shows, the PTI does not rule out direct effects of output changes on inflation, and the case is illustrated in Annex 3 of expansionary fiscal policy triggering portfolio effects that cause output to drop, inflation to decline, and the real exchange rate to appreciate.
An alternative theory of inflation (I). The PTI is alternative to conventional “demand-pull” theories of inflation. As the name of the theory is intended to suggest, inflation originates from the optimal (re)composition of country liabilities within the global investor portfolios: changes in domestic prices are the consequence of changes in the quality of those liabilities as they are perceived by global investors. If the quality of a country currency or bonds (relative to other country currencies or bonds) is expected to deteriorate, due to their anticipated unorderly dynamics, the demand for the currency or bonds will decline and their relative price will fall, causing the price of competing assets, commodities, and goods to increase.
An alternative theory of inflation (II). An important implication of the above features is that the PTI explains how identical policies may attain different outcomes in different countries. For instance, active demand management policies in poorly credible countries may fail to stimulate output and might instead cause inflation to rise (even in the presence of large output gaps) and capital to flee the economy, due to an inelastic IBC and unanchored inflation expectations. On the other hand, in highly credible countries with more elastic IBC (as determined by global investors) and strongly anchored expectations, the same policy shocks may achieve the desired results in terms of output and real resource use, with limited or no dissipative effect on the exchange rate and inflation. The PTI can thus explain the different slopes that the Phillips curve features in different countries, with credible countries showing flatter curves and less credible countries showing more vertical ones, and with flat curves in highly credible countries becoming even flatter in times of global crisis.
Finally, three possible misconceptions about the PTI should be avoided:
First misconception: The PTI is another way to show the old thesis whereby a “heavily indebted” economy is exposed to capital outflows and, hence, currency depreciation and higher inflation. That is not the case: the PTI endogenizes IBC elasticity and explains inflation as a possible (not necessary) outcome of investor portfolio choices. Even in the case of a largely indebted country, if investors believe that the country is strongly credible, they will accept (and finance) even large levels of its indebtedness (i.e., the IBC would be more elastic). Policies would affect output and would not dissipate into higher inflation through exchange rate devaluation. The contrary would hold, ceteris paribus, for poorly credible countries.
Second misconception: The PTI repackages the old idea that currency devaluations are the principal cause of inflation. Yes, the transmission from currency devaluation to inflation is instrumental to the PTI; yet the PTI goes much beyond this mechanism. The theory shows how macro-policy ineffectiveness may dissipate into higher inflation in countries that suffer from low policy credibility, but also identifies the conditions under which policy ineffectiveness does not translate into higher inflation, despite currency devaluation. In fact, according to the PTI, the link between exchange rate devaluation and inflation is influenced by country credibility, since it depends on the anchoring of inflation expectations: the stronger the anchoring, the lower the ERPT effect.
Third misconception: The PTI is another way to say that policies are neutral, and money is always a veil. Not at all: the PTI shows that monetary and fiscal policies are “ineffective” (as different from “neutral”) in countries with low credibility, and vice versa in highly credible countries – where “ineffectiveness” refers specifically to the policy impact on output. Regarding prices, even when policies are ineffective, it would not be necessarily the case that higher money growth or an expanding fiscal deficit translate into higher inflation. The PTI shows that, depending on country credibility, investor portfolio choices might even cause output to drop and inflation to decline, as a response to expansionary policies (see, for instance, illustrations in Appendix 3). All such outcomes are far from neutrality as conventionally understood in the context of macroeconomic policies.
The forces of globalization demand that each country considers realistically how effective its macro-policies can be, given its own characteristics and circumstances. This is especially (though not exclusively) important for developing and emerging market economies. In fact, current macroeconomic policy modeling continues to rely on domestic representative agents responding to state-driven policy impulses and fails to recognize the power global investors wield in determining the value at which public sector liabilities (money and debt) trade in the markets. This power may affect the policy impulses, altering policy effectiveness.
Correcting this shortcoming is what I set out to do with my work on the Portfolio Theory of Inflation, cited earlier, where I have analyzed how financial globalization affects the policy space available at the national level – in many cases constraining it to the point of rendering expansionary macro-policies ineffective or outright destabilizing.
This article has revisited the PTI as originally defined, further articulating its findings and implications. It has added to the micro- and macro-foundations of the PTI model of the economy, framing more rigorously the role of global investors and their international capital allocation choices, and providing richer analysis of their effects on inflation and output. In the process, the revisitation has allowed to correct errors contained in the previous formulation of the theory.
The article has explored additional dimensions of how capital allocations by global investors interact with government macro-policies and impact nominal exchange rate and inflation, and has discussed in greater depth the role of global investors in today’s internationally highly financially integrated economies, showing how this role constrains or relaxes the policy space of the national authorities, depending on the credibility that global investors attribute to them, and has integrated the micro side of the PTI model of the economy using asset utility analysis.
The article’s revisited model has been employed to derive and evaluate new results on the dynamics of exchange rate, inflation, and output following macro-policy shocks, concluding that the level of credibility attributed by global investors to a country’s policy making capacity determines the policy space available to the country’s authorities. In other words, where all else is assumed to stay the same, credibility determines the ultimate effectiveness (in terms of output) of the macro-policies adopted by the government, as the government choices underpinning such policies retroact on global investor allocation decisions, the value of the government’s liabilities (money and debt), and its sustainability.
Funding information: This research received no specific grant from any funding agency, commercial or nonprofit sectors.
Conflict of interest: Author states no conflict of interest.
Article note: As part of the open assessment, reviews and the original submission are available as supplementary files on our website.
Credibility Factor “ ”
Credibility factor “ ” condenses global investor views on the policy credibility of individual country economies. This factor can indifferently be thought of as an index that investors apply to the government IBC, which scales its value up or down correspondingly, or as a probability measure that generates an expected value of the IBC, or else as a risk factor that adjusts the value of the IBC. All else equal, a lower reflects larger expected losses on government debt (either via higher inflation or default) and translates into a tighter IBC for j’s government, thus requiring larger (and possibly more frontloaded) fiscal efforts to sustain a given debt stock.
The information set , at any time t, comprises all relevant information that global investors deem relevant to their decision-making process, including to assess the policy credibility of a country government (e.g., economic, political, and social factors, both internal and external to the country, which influence the achievability and sustainability of the government’s specific policy commitments). New factors or events that raised the investors’ concerns that country j’s government might face future economic, political, and social challenges (which would eventually induce the government to take such actions as defaulting on its future obligations, inflating its debt away, or even repudiating it) would be incorporated in a new information set and cause to fall ( ), thus reducing the IBC elasticity accordingly. A fall of credibility might result in such a tightening of the IBC elasticity that investors would doubt the sustainability of the future primary surpluses and/or debt monetization required by the tightened IBC, until such a point where they might even stop buying and holding the country’s debt altogether. This would cause the price of debt to collapse and, correspondingly, domestic interest rates to rise abnormally to levels where fiscal dominance would put pressure on the monetary authorities to monetize and inflate the debt away.
The relevant information set would also capture those developments (including, for instance, the evolution of local and/or global risks) that may induce investors to shift capital from lower-credible to higher-credible countries considered to be safer places for investment or issuers of safer liability instruments. In such instances, the credibility gap between countries (as perceived by the markets) may change and cause different dynamics of credibility factors and, hence, different IBC elasticities in different countries over time. All else equal, different IBC elasticities across countries are sufficient to make otherwise identical bonds imperfect substitutes of one another.
Derivation of the Asset Utility Function
Following Bossone (2014), at each point in time and across its life, any asset Q delivers to its holder a level of utility that reflects the opportunity for the holder to liquidate the asset and to use the proceeds from liquidation to finance consumption needs C occurring with probability at any future date. The utility of asset Q at date t is calculated by summing over two terms: (i) the utility directly derived from converting the asset into consumption at the next date t + 1 with probability and (ii) the utility indirectly derived from holding the asset further on with residual probability , which in turn can be further decomposed as above at each future date. Notice that probabilities are based on subjective judgments of asset holders and can change over time, also based on new information and changes in market sentiment.
Substituting iteratively for at each forward date yields across the time horizon, the process generates the following series of expressions:
and so on for each subsequent substitution of , for each date until the end of the time horizon. Notice that, as in the macro side of the model, expectations are based on information set available to the investors at each date t, which has been dropped for ease of exposition. Since wealth (and, therefore, every asset held in the portfolio) must be converted into consumption by the end of the time horizon, holdings of Q vanish in the limit as . Thus, summing over the agent’s infinite time
horizon gives the utility of asset Q at date t as
The cost of asset liquidation
Liquidating assets may involve resource costs such as for information acquisition, search, evaluation and verification, legal and administrative requirements, bargaining and negotiations, etc. Depending on the efficiency of the financial system where asset trading takes place, as well as on the state of market mood, each asset Q requires its own minimum amount of time (to be defined more precisely below) for its holder to be able to sell it at the ongoing market price , net of unit liquidation cost . If the agent is compelled to realize the asset within a time interval , then she must be willing to accept a sale price lower than , that is, the asset must sell at a price discount larger than the unit liquidation transaction cost under optimal timing . The liquidity of asset Q is therefore variable and endogenously determined, and can be modeled in terms of the following structure for asset liquidation cost
if , then, : the seller has enough time to liquidate Q and pays only for the transaction;
if then, : the seller does not have enough time and must sell Q at a discount larger than the optimal unit transaction cost;
: the discount increases with the time pressure on the seller to sell Q; and
if , then, : Q is perfectly liquid (cash),
and where , with , ,
that is, the minimum time interval required to sell Q optimally decreases with structural variable , which reflects the level of financial system efficiency in the trading of asset Q (including such features as technology; market platform, legal, regulatory and supervisory infrastructure, etc.), and increases with , which captures the prevailing market sentiment for trading Q, with a high (low) indicating the state of exuberance (pessimism) in the market for Q as perceived by the agents (which is not discussed in this appendix, but is illustrated at length in Bossone (2014)). Thus, greater (lower) efficiency of the financial infrastructure where Q is traded and a “seller” (“buyer”) market would shorten (lengthen) and lower (raise) q.
Since, at any time T > t, the expected utility lost to the liquidation of asset Q, inherited from time t, is a fraction of the expected utility from the consumption financed through the proceeds of Q,
where , , , .
Then, equation (A2) can then be rewritten as
which appears as equation (15) in the text.
Note that if asset Q is cash, or M, then , , , , and , although if cash were digital, this would allow for since the issuing CB would be able to apply positive or negative interest rates on it.
The model above can be extended to show how asset utility changes with the variability of asset prices and with changes in the market sentiment.
Credibility and Macro-Policies
The PTI model allows to evaluate the effects of active fiscal and monetary policies of a government by analyzing how policy stimuli are financed and how the government’s financing strategy is judged by the financial markets. Here the transmission mechanisms are described in a narrative form.
Assume that a largely indebted government engineers a persistent fiscal stimulus through the issuance of new domestic debt for an indefinite period to keep the real output gap down at zero. If the government’s credibility is low, investors determine an inelastic IBC and require government to commit to attaining larger primary surpluses over the immediate future to keep bond prices from falling. In fact, for economies that already suffer from low credibility, especially those already carrying large debt positions, the very intention of relaxing macro policies might be perceived by the markets as further weakening credibility, thus tightening the government IBC. A tight(er) IBC makes the effect of the stimulus small(er) and short-lived, if at all. Moreover, if the government does not (credibly) commit to attaining larger future primary surpluses, based on the new information set, bond prices fall as investors sell domestic bonds for foreign assets, leading to higher interest rates and a contraction in the supply of money engineered by the central bank to accommodate higher rates, which would stymie currency depreciation. Under such conditions, the country’s credibility could drop to a critical level that neutralizes the positive effect on real output of both the fiscal stimulus and real exchange rate depreciation (Figure 1a).
Consider now the central banks decision to stimulate the economy by lowering the domestic policy rate and committing to keep it low for a protracted period by supplying more money through periodic purchases of government bonds. The share of domestic bonds held by the central bank increases (at an unchanged level of total outstanding government debt) and, correspondingly, global investors reallocate their portfolio toward foreign bonds since the marginal utility of the money balances they have received in exchange for selling bonds to the central banks has declined. This is because they now hold domestic money balances in excess to optimal balances. Therefore, ceteris paribus, portfolio compositions would feature higher shares of foreign assets relative to domestic assets determining a higher nominal exchange rate. While nominal exchange rate depreciation may in principle amplify the stimulus, the intensity and duration of its effect ultimately depend on the amplitude and speed of the real exchange rate adjustment process (Figure 1b).
The policy authorities should be mindful of the impact of credibility on the country’s IBC. While high credibility raises the effectiveness of monetary policy, low credibility, or the erosion of credibility in the eyes of the markets, reduces it. A country’s credibility might drop to such a critical level that it neutralizes the effect of monetary stimulus on the nominal interest rate, and hence on real output, while the largest part of the effect would dissipate into nominal exchange rate depreciation and higher inflation.
If the central bank and government coordinate their acts and engineer a monetary financing of new debt issuance aimed to support fiscal stimulus large enough to stabilize the interest rate (a.k.a. “helicopter money”), no negative effects retrofit on real output. As a result, the fiscal-monetary impulse is unencumbered, and the policy program can be calibrated to stabilize real output at full capacity without causing inflationary pressure. This result is consistent with Buiter’s (2016) conclusion that “helicopter money always works.”
The monetary authorities should always consider the impact of their action on the exchange rate. If the stimulus is temporary, and the pass-through less than complete, the nominal exchange depreciation that follows the temporary excess supply of money amplifies the stimulus. However, under a persistent monetary financing of the fiscal deficits, the ongoing excess money creation affects the nominal exchange rate and the inflation rate, causing credibility to drop, the ERPT effect to increase, and the exchange rate and inflation to further rise. Thus, while policy coordination may achieve the best result possible, it is not by itself sufficient for the country to gain credibility in the eyes of the market.
Thus, as discussed in Section 7, there is no mechanical correspondence between changes in government liabilities (money and/or debt), the exchange rate, inflation, and real output. The correspondence is country-specific, it depends on the country’s credibility as perceived by the markets (Figure 2) and may change with government efforts (or lack thereof) to gain credibility.
Finally, consider situations where critical international developments (e.g., political turmoil, financial crises, major calamities) induce investors to shift capital to countries with high credibility, which are generally regarded as safe havens. In such situations, as the PTI suggests, the credibility gap may widen with the consequences that the IBC of the highest-credible countries becomes even more elastic, the policy space available to these countries for expansionary action increases further and, all else equal, their rate of inflation declines, while the opposite happens to the lowest-credible countries. In such cases, the credibility gap widens not because the authorities of the highest-credible countries have tightened their policy commitments, but because investors searching for asset protection value their credibility relatively more at times of stress.
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