Bringing Global Finance into Macro-Policy Analysis

The Portfolio Theory of Inflation (PTI) brings global finance into macroeconomic policy analysis, and addresses Obstfeld and Taylor’s (2017) remark that standard models of macroeconomic stabilization do not pay sufficient attention to finance. In particular, the PTI approach shows that: (1) in an open and globally financially integrated national economy the effectiveness of macroeconomic policies depends on the level of credibility that financial markets attribute to the economy, in particular its policy authorities and policy stance (2) whereas the monetary policy trilemma constrains countries to enjoy at most only two of the three possible states (i.e. exchange-rate stability, freedom of cross-border payments, and economic policy autonomy), the trilemma does not constrain all countries equally if they operate in a context of high international financial integration: credible countries enjoy greater space for effective policies than less credible countries (3) not all countries benefit equally from a floating exchange rate regime, either; the latter offers credible countries greater space for policy effectiveness and protection against external shocks, while such space gets progressively thinner as country credibility weakens (4) an open economy that is fully financially integrated, internationally, with large public debt and poor policy credibility does not stand to gain much in terms of shock insulation and policy autonomy from either issuing liabilities in its own (rather than a foreign) currency or adopting a flexible (rather than a fixed) exchange rate regime (5) however, all else being equal, the benefits from a floating exchange rate regime increase with the degree of the economy’s policy credibility.