Bossone, Biagio; Cuccia, And ea
Wo king Pape
The po olio heo y o in la ion and policy
(in)e ec i eness e isi ed: Co obo a ing e idence
Economics Discussion Pape s, No. 2020-2
P o ided in Coope a ion wi h:
Kiel Ins i u e o he Wo ld Economy – Leibniz Cen e o Resea ch on Global Economic Challenges
Sugges ed Ci a ion: Bossone, Biagio; Cuccia, And ea (2020) : The po olio heo y o in la ion and
policy (in)e ec i eness e isi ed: Co obo a ing e idence, Economics Discussion Pape s, No. 2020-2,
Kiel Ins i u e o he Wo ld Economy (I W), Kiel
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Discussion Pape
No. 2020-2 | Janua y 08, 2020 | h p://www.economics-ejou nal.o g/economics/discussionpape s/2020-2
The po olio heo y o in la ion and policy
(in)e ec i eness e isi ed: co obo a ing e idence
Biagio Bossone and And ea Cuccia
Abs ac
This s udy e isi s and es s empi ically he Po olio Theo y o In la ion (PTI), which
analyzes how he e ec i eness o mac oeconomic policy in open and globally inancially
in eg a ed economies is in luenced by global in es o decisions (Bossone, The po olio
heo y o in la ion and policy (in)e ec i eness, 2019). The PTI shows ha when an
economy is hea ily indeb ed and is pe cei ed by he ma ke o be poo ly c edible, in es o s
hold i o a igh e in e empo al budge cons ain and policies aimed o s imula e ou pu
g ow h dissipa e in o domes ic cu ency dep ecia ion and highe in la ion, wi h limi ed o
no impac on ou pu , o wi h lowe ou pu and lowe in la ion. On he o he hand, ma ke s
a o d highly c edible economies much g ea e space o e ec i e and nonin la iona y
mac o policies. The s udy leads o a e y basic ad ice: policymake s o an in e na ionally
highly in eg a ed economy should keep public liabili ies ( he s ock o bo h cen al bank
money and public deb ) a low le els: he la ge he liabili ies, he highe he deg ee o
su ende o he coun y’s na ional policy so e eign y o ex e nal o ces and in e es s.
JEL E31 E4 E5 E62 F31 G15 H3
Keywo ds C edibili y; exchange a e; inancial in eg a ion; iscal and mone a y
policies; global in es o (s); in la ion; in e empo al budge cons ain ; policy
e ec i eness; public deb
Au ho s
Biagio Bossone, In e na ional Financial Ad iso , [email protected]
And ea Cuccia, Uni e si y o Pale mo, Pale mo, I aly
Ci a ion Biagio Bossone and And ea Cuccia (2020). The po olio heo y o in la ion
and policy (in)e ec i eness e isi ed: co obo a ing e idence. Economics Discussion
Pape s, No 2020-2, Kiel Ins i u e o he Wo ld Economy.
h p://www.economics-ejou nal.o g/economics/discussionpape s/2020-2
Recei ed Decembe 18, 2019 Accep ed as Economics Discussion Pape Janua y 7, 2020
Published Janua y 8, 2020
© Au ho (s) 2020. Licensed unde he C ea i e Commons License - A ibu ion 4.0 In e na ional (CC BY 4.0)
2
THE PORTFOLIO THEORY OF INFLATION AND POLICY
(IN)EFFECTIVENESS REVISITED: CORROBORATING EVIDENCE
Biagio Bossone and And ea Cuccia(∗)
«I a leading p esiden ial candida e in an eme ging ma ke
los a o wi h Wall S ee , he banks would pull hei money
ou o he coun y. Vo e s hen aced a s a k choice: Gi e in
o Wall S ee o ace a se e e inancial c isis. I was as i
Wall S ee had mo e poli ical powe han he coun y’s
ci izens»1
1. INTRODUCTION
Why is i ha , in Japan, expansiona y iscal and mone a y policies o unp eceden ed du a ion and
in ensi y ha e achie ed high employmen a i ually ze o in la ion, while conside ably lesse s imuli
in Tu key ha e caused he li a o collapse and in la ion dange ously o ise? And why is i ha o e
he las decade he US Fede al Rese e and T easu y ha e succeeded in b inging unemploymen
down o his o ic eco d lows wi hou o e hea ing he economy, while in he same pe iod an i-
ecessiona y iscal and mone a y expansion in Mexico only esul ed in cu ency dep ecia ion and
highe in la ion (Ahumada, 2009 and Angulo-Rod iguez, 2011)? And specula ing u he : would a
coun y like I aly eco e e ec i e so e eign y o e mac oeconomic policy i i exi ed he eu o?
(∗) Respec i ely, in e na ional inancial ad iso and Ph.D. in Model-based public planning, policy design and
managemen , Uni e si y o Pale mo. Biagio Bossone has co e ed he heo y sec ions and has con ibu ed o
he empi ical es design and iden i ica ion o he analy ical amewo k. And ea Cuccia has de eloped and
p oduced he empi ical analysis.
1 Quo ed om S igli z. J. E., The End o Neolibe alism and he Rebi h o His o y, P ojec Syndica e, 4
No embe 2019.
3
The abo e ques ions can be add essed using Po olio Theo y o In la ion (PTI), which his
s udy se s ou o e isi and es empi ically. The PTI a gues ha in an open and globally inancially
in eg a ed economy he e ec i eness o mac oeconomic policies depends on he le el o c edibili y
ha inancial ma ke s a ibu e o he economy, in pa icula i s policy au ho i ies and policy s ance
(Bossone, 2019).2 He e, "global inancial in eg a ion" means ha he public liabili ies o a coun y
a e aded in he in e na ional inancial ma ke s and hei p ices a e de e mined by in es o s who i)
manage hei po olios aking a global pe spec i e on local in es men oppo uni ies (in a sense ha
will be de ined below) and ii) a e capable o shi capi al in and ou o he coun y swi ly and a
negligible ansac ion cos s. Global inancial in eg a ion causes ele an sha es o domes ic (p i a e
and public) asse s and liabili ies o be managed as global po olios.3
Consequen ly, while in a highly c edible economy mac oeconomic policy shocks would be
e ec i e in s imula ing ou pu du ing a ecession,4 i he same shocks we e enac ed by he policy
2 Based on he app oach in oduced in mac oeconomics by Backus and D i il (1985a, b), ollowing he wo k
o K eps and Wilson (1982), his s udy de ines "policy c edibili y" – as e e ed o a go e nmen – as he
ex en o which economic agen s belie e he go e nmen will ca y ou he mac oeconomic policies i has
p omised o pu sue. Impo an ly, his no ion ela es o bo h he will and abili y o he go e nmen o deli e on
i s p omise. Ma ke judgmen s on policy c edibili y, hus, d aw on a coun y’s pas policy ack eco d, i s
esol e o pu sue p e-announced policy commi men s and a ge s, and he adhe ence o i s policy amewo k
o wha ma ke s conside o be sound inancial s abili y c i e ia (such as, ypically, low in la ion, s able asse
p ices, high liquidi y and sol ency o inancial ins i u ions, low le e age o key sec o s, e c.).
3 The e ec o global inancial in eg a ion would be ein o ced by a high incidence o ins i u ional in es men
o e o al domes ic sa ings and by a la ge concen a ion o domes ic weal h, since bo h ea u es magni y he
ole o he global in es o s in he p ice de e mina ion p ocess o he aded liabili ies.
4 This should be o no su p ise conside ing in pa icula he case o hose coun ies whose cu encies o e sa e
ha en a imes o high unce ain y. The policy space a ailable o hese economies expands especially du ing
hose imes, when bo h domes ic and o eign in es o s demand mo e o he asse s denomina ed in hei
cu encies. In p ac ice he iscal and mone a y au ho i ies o hose coun ies can issue wha e e amoun o
4
au ho i ies o a poo ly c edible and la gely indeb ed economy o coun e ac , say, a ecession o
economic s agna ion, capi al would likely lee he coun y, he nominal exchange a e o he na ional
cu ency would dep ecia e, and domes ic in la ion would ise, wi h only limi ed e ec s on he
economy’s eal a iables. Only o he ex en ha ou pu we e o ecede e en u he (indeed, a
possible ou come, as discussed la e ), would exchange a e de alua ion and in la ion be dampened.
Said di e en ly: acco ding o he PTI, he in eg a ion o a na ional economy in o he global
inancial ma ke s con e s on he la e he powe o c ea e o o des oy he policy space a ailable o
he economy, ha is, he powe o expand o o na ow he bounda ies ha delimi he use he
economy’s iscal and mone a y policy ins umen s un il hey comp omise he sus ainabili y o he
go e nmen ’s inancial posi ion o he s abili y o he economy.5 The ampli ude o he bounda ies
(i.e., he ex en o he policy space) depends on how c edible global ma ke s belie e hose policies,
and he policymaking ins i u ions behind hem, o be agains he backg ound o he economy’s
po en ial. And since global in es o s manage hei posi ions in e empo ally, he bounda ies hey se
o each economy a each poin in ime de e mine he elas ici y o he economy’s in e empo al
budge cons ain (IBC) and, hence, he economy’s deg ees o eedom o bo ow esou ces om he
u u e o p esen uses: when in es o s deem a coun y’s c edibili y o be low, he economy is ied o
a igh e IBC and he issuance o public sec o liabili ies (in he o m o money o deb unde any
cu ency o denomina ion) aimed o s imula e ou pu g ow h dissipa es ins ead in o domes ic
cu ency dep ecia ion and highe in la ion.6 Such "p ice" dissipa ion e ec s would only be dampened
money and deb obliga ions hey wish since hese will be abso bed by he ma ke . The abso p ion may in ac
be such ha he new issuances migh be accompanied by unchanged o e en inc easing p ices.
5 In he spi i o his s udy, as i will become clea e la e , e e ence o he go e nmen ’s inancial posi ion o
he s abili y o he economy includes no only he sus ainabili y o public deb bu also he in e nal and
ex e nal s abili y o he alue o he na ional cu ency.
6 The concep s o c edibili y and excess liabili ies will be cla i ied in Sec ion 3.

5
i he igh e IBC we e o dep ess ou pu , an op ion no o be uled ou and discussed la e . On he
o he hand, i he same expansiona y ac ion is unde aken by a highly c edible go e nmen , a mo e
elas ic IBC allows ou pu o expand wi h no o limi ed dissipa i e e ec s on he economy’s nominal
a iables.
In wha ollows: Sec ion 2 ela es he PTI o he exis ing ele an li e a u e; Sec ion 3
discusses he cen al ole ha global in es o s play in he con ex o he PTI; Sec ion 4 p o ides a
o mal ep esen a ion o he PTI and analyzes i s main esul s; Sec ion 5 discusses some peculia
ea u es o he PTI as a heo y o in la ion in oday’s global con ex ; Sec ion 6 p o ides empi ical
e idence in suppo o he heo y; and Sec ion 7 de elops some gene al e lec ions on he PTI.
Sec ion 8 concludes he s udy.
2. RELATIONS WITH THE LITERATURE
The pilla s unde pinning he PTI a e i) he po olio balance app oach (PBA) o exchange a e
de e mina ion, as modi ied o inco po a e in e empo al choices om global in es o s, and ii) he
ela ionship be ween policy c edibili y, exchange a e and in la ion. Re e ences o he ele an
li e a u e on hese wo pilla s a e con ained in Bossone (2019). The only addi ion, he e, e e s o he
second pilla and is he wo k by Ahumada (2009), which shows ha iscal expansion in Mexico
leads o eal exchange a e dep ecia ion (in spi e o an upwa d end in in e es a es) and explains
his inding e oking he so-called coun y isk iew o iscal policy, whe eby iscal loosening in
de eloping coun ies may induce isk-a e se in es o s o ans e unds ab oad in o de o a oid
domes ic in la iona y axes, exchange a e isk and o he po en ial haza ds commonly associa ed wi h
6
unsound public inances. Such capi al ou lows may, in u n, weaken he domes ic cu ency in eal
e ms e en wi h a highe a e o e u n on he peso-denomina ed bonds.7
3. FINANCIAL INTEGRATION AND THE ROLE OF GLOBAL INVESTORS
Two c i ical aspec s cha ac e ize a globally inancially in eg a ed economy: he cen al ole o global
in es o s as esou ce alloca o s and he neu ali y be ween he cu ency denomina ion o he
economy’s liabili ies.
Global in es o s
The PTI’s co e es s on he cen al ole played by he ep esen a i e "global inancial in es o " in he
na ional esou ce alloca ion p ocess, in lieu o he ep esen a i e (domes ic) household ha ypically
unde pins all con en ional choice heo ies. The o me , much mo e han he la e , a e sensi i e o
exchange a e dynamics and ake a global iew o in es men oppo uni ies and isks. Ac ing as
"ma ginal" in es o s, global inancial in es o s ha e he la ges in luence on he p icing o hei
ades and de e mine he p ices a which ades a e execu ed, including hose o he smalle
(domes ic) household sa e s (see Sec ion 4).8
To he ex en ha p ices a e de e mined by global in es o s, asse alues a e d i en by he
expec ed dynamics o in e na ional asse p ices. This is because, unlike domes ic households, global
in es o s do no use domes ic in la ion a es o gauge he eal alue o hei in es men asse s, bu
7 Acco ding o he coun y isk iew, inc easing budge de ici s (especially in de eloping coun ies) a e
usually deemed by in e na ional in es o s as an ea ly wa ning indica o , ha is, as a signal o de e io a ion in
he economy’s undamen als and may o igina e massi e capi al ou lows ha lead o exchange a e
dep ecia ion e en wi h inc eased eal in e es a es. See Ahumada (ci .) o e e ences o he main p oponen s
o his iew.
8 Fo a s udy on he ma ginal in es o and a e iew o he ma ginal in es o in he inance li e a u e, see
Ba holdy and Ka e (2004) and e e ences he ein, and see mo e ecen ly Chen and Lei (2015).
7
conside ins ead he ela i e dynamics o he exchange a es ac oss he ele an cu encies (o a leas
wha hey expec hose dynamics o be du ing he ele an ime ho izon), which may di e
(subs an ially and pe sis en ly) om he unde lying pu chasing powe pa i ies. 9 In such
ci cums ances, domes ic in la ion a es a e de e mined by he exchange a e dynamics ( a he han
ice e sa): he mo e open is a coun y’s economy and he mo e lexible i s p ices, he g ea e is he
ansmission om exchange a e changes o domes ic p ices ( h ough he ERPT e ec ).
Also, when aced wi h he p ospec s o a coun y issuing "excess" liabili ies,10 global
in es o s eplace a he ele an ma gin bo h domes ic deb and money holdings wi h o eign asse s
deemed o be sa e s o es o alue.11 Thus, in poo ly c edible and la gely indeb ed economies highe
in la ion can ma e ialize e en a posi i e le els o he ou pu gap, as a e lec ion o he g ow h o
public liabili ies and hei impac on he cu ency’s exchange a e.
Neu ali y o cu ency denomina ion
9 Global in es o s a e no consume s, and unlike consume s hey a e no in e es ed in exp essing he eal alue
o hei asse s in e ms o any domes ic consume p ice index.
10 The concep o "excess" liabili ies may be unde s ood in ci cums ances such as when public liabili ies
exceed he alue o nominal agg ega e ou pu and bo h g ow a he same a e, causing he di e ence be ween
he wo a iables o g ow inde ini ely, beyond he poin a which he holde s o he liabili ies migh no longe
be willing o abso b hem, excep pe haps a exo bi an (and ye unsus ainable) in e es a es. Holde s would a
some poin s a di e si ying hei po olio in o al e na i e asse s, including hose denomina ed in o eign
cu encies, and indeed e y apidly so in he e en ha he a io we e an icipa ed o g ow as . No ice ha his
would happen independen ly o inc easing in la ion expec a ions, and simply as a esul o po olio
ebalancing e ec s. In ac , as will be explained below, highe in la ion (and in la ion expec a ions) could be
he consequence, no he causing ac o , o such po olio ebalancing e ec s.
11 O cou se, domes ic agen s would s ill demand he domes ic cu ency o ansac ion and ax paymen
pu poses, bu such demand migh no be enough o p e en he cu ency om dep ecia ing i people mo e
la ge sha e o weal h ou o i and in o al e na i e asse s (including o eign cu ency denomina ed ones).
8
I is o en a gued ha a go e nmen ha spends i s own cu ency canno be o ced in o de aul
in ha cu ency.12 Ye , al hough deb con ac s a e ypically s ipula ed in nominal e ms, c edi o s a e
keen on making su e ha hey e en ually eco e he ull eal alue o hei lending (inclusi e o he
in e es income). Repaying lende s in a cu ency ha dep ecia es, and whose a e o dep ecia ion is
no ully compensa ed, is no a de aul in legal e ms bu is economically equi alen o i and lende s
wan o a e he isk and be compensa ed o being exposed o i .
We e i no so, he e would in p inciple be a “ ee lunch” ha go e nmen s could bene i om
by bo owing in a domes ic cu ency ha hey can p in in unlimi ed amoun s. This happens any ime
a go e nmen is in a posi ion o exploi domes ic bo owe s, ei he because hey a e small,
unin o med and wi h limi ed in es men capaci y, o because hey ope a e in segmen ed o cap i e
domes ic capi al ma ke s. On he o he hand, when na ional economies a e globally inancially
in eg a ed and hei liabili ies ade in he in e na ional capi al ma ke s, global in es o s e alua e he
deb epaymen capaci y (in eal esou ces) o he bo owe s (say, go e nmen s), and such capaci y is
in ac he same whe he he con ac s a e w i en in domes ic o o eign cu encies. The ac ha a
go e nmen may p in in ini e amoun s o domes ic cu ency (which i may no do in o eign
cu encies) does no al e - ex an e - he ( eal) losses ha he in es o s expec om con ac s
exp essed in di e en cu encies: con ac e ms would in any case be w i en so ha he in es o s
would be indi e en be ween he cu encies o denomina ion. Tha is, he con ac s would ca y
e ms and condi ions ha p o ec he in es o s om he isk o de aul in all cases, whe he his
o igina es om he in e up ion o he deb se ice o om deb epaymen aking place in a
dep ecia ing cu ency. The deb o is he same as well as i s capaci y o epay (in eal e ms), and he
same is he e o e he isk aced by in es o s.
12 See, o ins ance, Ve nengo and Pé ez Calden ey (2019).
15
A go e nmen ha consis en ly p o ed capable and willing o sa is y Eq. (1) would be
pe cei ed as c edible by he ma ke s, and ice e sa. The s onge i s c edibili y (a high 𝛽), he highe
he "elas ici y" o i s IBC and he g ea e he ma ke ’s eadiness o abso b la ge amoun s o i s
liabili ies. On he o he hand, wi h weake c edibili y (a low 𝛽), he p ospec s o i being capable and
willing o aise su icien u u e esou ces o epay i s obliga ions would be pe cei ed as mo e
unce ain by he in es o s and he IBC would cause bond p ices o all; he u he e osion o
c edibili y migh e en lead in es o s o no longe buy o hold domes ic bonds and o shi hei
po olios owa d o eign asse s.
Eq. (1) epi omizes he essence o he PTI de eloped in his s udy, in ha he heo y e lec s
he ul ima e subjec i e na u e o ma ke pe cep ions (as exp essed in he in es o s’ expec a ions,
conjec u es, and con en ional belie s) ha a e ele an o e alua e he c edibili y o na ional
economic policies and he con idence han can be placed on he coun y’s policy egime and
ins i u ions.20
Sol ing he model ep esen ed by he abo e equa ions o he domes ic p ice le el exp essed
in loga i hmic o m (see Appendix 1) yields:
(14) 𝑝�𝐷,𝑡≈𝜙( ∙ ) + 𝐿−1���𝛽𝐹,𝑡+1−𝛽𝐷,𝑡+1�+�𝑚�𝐷,𝑡+1−𝑚�𝐹,𝑡+1�+�𝑏�𝐷,𝑡+1−𝑏�𝐹,𝑡+1�+
�𝚤𝑡+1
𝐵𝐹−𝚤𝑡+1
𝐵𝐷�) + 𝑝�𝐹,𝑡�+π𝐷,𝑡( ∙ )�,
20 Mo e goes in o Eq. (1) han he me e e alua ion o s ock- low consis ency. To see his, conside ha , all else
equal, he same s ock o public deb may co espond o e y di e en spending and ax policies ha a
go e nmen may decide o adop , wi h di e en implica ions o he iscal mul iplie s and he economy’s
supply side. Di e en policies would impac di e en ly he g ow h pa h o he economy and i s capaci y o
gene a e u u e iscal su pluses, he eby inducing inancial ma ke s o assess di e en ly he policy c edibili y
o he au ho i ies and o de e mine a di e en elas ici y o he go e nmen IBC, as ea lie de ined.

16
whe e he ilde indica es he pe cen age de ia ion o a iables om hei s eady s a e (op imal)
alues. Acco ding o Eq. (14), o a gi en ERPT ac o 𝜙( ∙ ) and ze o ne excess in e nal demand
π( ∙ )= 0, domes ic in la ion a ies di ec ly wi h:
i. changes in coun y c edibili y gap, as pe cei ed by he ma ke and based on new in o ma ion
and e-e alua ion o ele an economic da a. No e ha c edibili y a ec s in la ion bo h
di ec ly ( ia he c edibili y gap) and indi ec ly h ough he pass- h ough ac o ( he highe
domes ic c edibili y, he lowe he pass- h ough, and he lowe he in la ion a e);
ii. changes in he ela i e dynamics o domes ic e sus o eign (cen al bank) money s ocks;
iii. changes in he ela i e dynamics o domes ic e sus o eign deb ;
i . changes in he in e es a es di e en ial on go e nmen bonds, and
. changes in he a e o o eign in la ion.
No ice ha he EPRT e m in Eq. (14) has nega i e sign, excep when he pass- h ough is
comple e and hus 𝜙(∙) = 𝑙𝑙1 = 0 . Wi h comple e pass- h ough, ins an aneous ela i e p ice
adjus men o o eign p ices, and no change in he ou pu gap, changes in he nominal exchange a e
eed ully in o domes ic in la ion ( ela i e o o eign).
Acco ding o Eq. (14), in la ion would be sensi i e o wha e e public liabili ies a e deemed o
be in "excess" is-à- is ele an o eign economies, i espec i e o hei na u e and denomina ion.
In e es ingly, Eq. (14) can be used o show ha in e na ional economic de elopmen s may
induce in es o s o mo e capi al o coun ies wi h high c edibili y ( hey show a la ge posi i e
�𝛽𝐹,𝑡+1 −𝛽𝐷,𝑡+1� di e en ial), and a e gene ally ega ded as sa e ha ens). In such si ua ions, he
c edibili y gap migh ac ually widen wi h he consequence ha he IBC o highes -c edible coun ies
becomes mo e elas ic, hei policy space o expansiona y ac ion inc eases and, all else equal, hei
a e o in la ion declines, while he opposi e happens o he lowes -c edible coun ies. No ice in such
17
cases ha he c edibili y gap widens no because na ional au ho i ies ha e necessa ily changed hei
policy commi men s, bu because he in o ma ion ca ied by he new de elopmen s induce in es o s
o sea ch o be e p o ec ion o hei esou ces; his is su icien o hem o s eng hen he
pe cep ion o c edibili y o hese coun ies is-à- is he o he s.
F om an ex-an e pe spec i e, Eq. (14) migh p o ide ambiguous indica ions depending on how
he dynamics o a coun y’s domes ic e sus o eign liabili ies in e ac s wi h he in e es a e
di e en ial on domes ic go e nmen bonds: a mo e han p opo ional inc ease in he la e would
dep ess he economy’s ou pu , s eng hen he exchange a e and lowe in la ion. In addi ion o he
po olio e ec , Eq. (8) and i s eedback on p ices h ough Eq. (4) sugges ha also a eal channel
migh be a play om he in e es a e di e en ial o in la ion.
C edibili y and mac o policies: An e alua ion
The model abo e allows o e alua e he e ec s o ac i e iscal and mone a y policies o a
go e nmen essen ially by analyzing how policy s imuli a e inanced and how he go e nmen ’s
inancing s a egy is judged by he inancial ma ke s.
Assume coun y D’s la gely-indeb ed go e nmen enginee s a pe sis en iscal s imulus h ough
he issuance o new domes ic deb ∆𝑏
�
�
�
�
𝜏𝐷>∆𝑏
�
�
�
�
𝑡𝐷, 𝜏=𝑡+ 1, … 𝑡+𝑙, o an inde ini e numbe o
pe iods n, in an a emp o keep he eal ou pu gap down a ze o (Eq. (8)). I he go e nmen ’s
c edibili y is low (a low 𝛽𝐷), in es o s de e mine an inelas ic IBC and equi e go e nmen o commi
o a aining la ge p ima y su pluses o e he immedia e u u e so as o keep bond p ices om alling.
In ac , o economies ha al eady su e om low c edibili y, he e y in en ion o elaxing mac o
policies migh be pe cei ed by he ma ke s as u he weakening c edibili y, hus igh ening he
18
go e nmen IBC.21 A igh (e ) IBC makes he e ec o he s imulus small and sho -li ed, i a all.
Mo eo e , i he go e nmen does no (c edibly) commi o a aining la ge u u e p ima y su pluses
( ha is, 𝛽𝐷,𝑡|𝜔𝑡1<𝛽𝐷,𝑡|𝜔𝑡), based on he new in o ma ion se 𝜔𝑡1), bond p ices all (Eq. (1)) as
in es o s sell domes ic bonds o o eign asse s, leading o highe in e es a es (Eq. (7)) and o a
con ac ion in he supply o money supply enginee ed by he cen al bank o accommoda e highe
a es and s ymie cu ency dep ecia ion. Subs i u ing Eq.’s (1) and (2) in o Eq. (7) and he esul ing
exp ession in o Eq. (8), cas ing he exchange a e as an implici unc ion o c edibili y and he in e es
a e om Eq. (A5) in Appendix 1, di e en ia ing o ally and se ing he esul ing exp ession equal o
ze o, yield
(15) ∆𝑋𝐷,𝑡=𝑋𝐷,𝑡− 𝑋𝐷,𝑡−1=
Χ1��𝜄−1�𝑃𝑡∑�𝜷𝑫,𝒕|𝝎𝒕𝟏�𝑛
∞
𝜏=𝑡 �𝑠𝐷,𝑡+∆𝑚𝐷,𝑡�
𝐵𝐷,𝑡−1+∆𝐵
�
�
�
�
𝐷,𝑡�− 𝑖𝑁
𝐵𝐷�∆𝑖𝑡𝐵𝐷+
�𝜄−1�𝑃𝑡∑�𝜷𝑫,𝒕|𝝎𝒕𝟏�𝑛
∞
𝜏=𝑡 �𝑠𝐷,𝑡+∆𝑚𝐷,𝑡�
𝐵𝐷,𝑡−1+∆𝐵
�
�
�
�
𝐷,𝑡�− 𝑖𝑁
𝐵𝐷�∆𝜷𝑫,𝒕�+Χ2�∆𝑒𝐷,𝑡
𝑃𝐷,𝑡𝜷𝑫,𝒕|𝝎𝒕𝟏+𝑒𝐷,𝑡
𝑃𝐷,𝑡∆𝜷𝑫,𝒕�+𝑋3 ∆𝑏
�
�
�
�
𝐷,𝑡= 0,
which shows ha , based on he new in o ma ion se , coun y D’s c edibili y could d op o a c i ical
le el 𝛽𝐷,𝑡|𝜔𝑡1 (ma ked in bold and ed in Eq. (15)), which neu alizes he e ec on eal ou pu o bo h
iscal s imulus ∆𝑏
�
�
�
�
𝐷,𝑡 and eal exchange a e dep ecia ion ∆𝑒𝐷,𝑡
𝑃𝐷,𝑡, such ha ∆𝑋𝐷,𝑡= 0; ye , he
iscal s imulus would inc ease he nominal exchange a e and in la ion ia Eq. (14). Howe e , in he
e en ha he nega i e c edibili y e ec he po olio and ou pu e ec s (Fig. 1a), he ecessiona y
21 An implica ion o his a gumen is he asymme ical ea men by he ma ke s o expansiona y e sus
con ac iona y policies. Whe eas he o me may weaken c edibili y, he eby u he limi ing he policy space
a ailable o policymake s, he le e s eng hens c edibili y and hus enhances go e nmen ’s abili y o a ec
eal a iables as desi ed. This issue o policy asymme y will no be u he pu sued he e.
19
impac on ou pu (as no ed, ia Eq. (8) migh be such as o e en ually lead o an app ecia ion o he
exchange a e and lowe in la ion.
Conside now he cen al bank’s decision o s imula e he economy by lowe ing he domes ic
policy a e (Eq. (7)) and commi ing o keep i low o a long pe iod by supplying mo e money
h ough pe iodic pu chases o go e nmen bonds. F om Eq.’s (1) and (6), he sha e o domes ic
bonds held by he cen al bank inc eases (a an unchanged le el o o al ou s anding go e nmen
deb ); co espondingly, global in es o s ealloca e hei po olio owa d o eign bonds since he
ma ginal u ili y o he money balances hey ha e ecei ed in exchange o selling he bonds o he
cen al banks has declined, as shows Eq. (A5) in Appendix 1.22 The la e equa ion also shows ha ,
ce e is pa ibus, po olio composi ions ea u ing highe sha es o o eign asse s ela i e o domes ic
asse s de e mine a highe nominal exchange a e. While he nominal exchange a e dep ecia ion may
in p inciple ampli y he s imulus, he in ensi y and du a ion o i s e ec ul ima ely depend on he
ampli ude and speed o he eal exchange a e adjus men p ocess (Eq. (14)).
22 This is due o he ac ha hey now hold domes ic money balances in excess wi h espec o op imal
balances (see 𝑀𝐻,𝑡
𝐷∗ in Eq. (A5), Appendix 1).
20
No e: Figu es 1a and 1b: he cu e MM is he locus o (i, X) pai s a which ∆𝑏= 0; he cu e FF is he locus o (i, X)
pai s a which
∆𝑚= 0
; and he schedule EE is he locus o (i, X) pai s a which
∆�𝑒
𝑃
�= 0
. Fig. 1a po ays he case
whe e he expansiona y iscal s imulus ∆𝑏> 0 is mo e han o se by he e ec s o he d op in he le el o policy
c edibili y as pe cei ed by he ma ke . The iscal au ho i ies ini ially shi he FF schedule igh wa d om FF0 o FF1 o
a highe le el o ou pu , which is only pa ially dampened by a highe in e es a e. Howe e , he lack o c edibili y
causes in es o s o sell o domes ic bonds in exchange o o eign asse s, and he mone a y and iscal au ho i ies o
adjus , espec i ely, he money and bond supply so as o keep balance in he bond and o eign exchange ma ke s. As a
esul , he EE and MM schedules shi , espec i ely, om EE0 up o EE1and om MM0 backwa d o MM1, and he FF
schedule mo es somewha backwa d o FF2, all c ossing each o he a an in e es a e ha mo e han o se s he ini ial
s imulus. As no ed in he ex , he adjus men p ocess migh be such as o e en ually lead o an app ecia ion o he
exchange a e, lowe ou pu and lowe in la ion, wi h he schedule EE shi ing backwa d o EE2. Fig. 1b ep esen s he
case whe e he expansiona y ou pu e ec o he mone a y impulse ∆𝑚> 0 is mo e han o se by he e ec s o he
d op in he le el o policy c edibili y as pe cei ed by he ma ke . The mone a y policy au ho i ies ini ially shi he
MM schedule om MM0 o MM1 o a lowe in e es and exchange a e le els. The lack o c edibili y, howe e , causes
in es o s o sell domes ic bonds o o eign asse s, causing he in e es a e o ise and he cu ency o weaken. The EE
schedule shi s upwa d om EE0 o EE1 and he mone a y au ho i ies mus sh ink he money supply as necessa y o
es o e equilib ium in he bond and o eign exchange ma ke s. As a esul , he adjus men migh be such as o e en
mo e han o se he ini ial s imulus.

21
Sho o he eal exchange a e e ec , he mone a y s imulus is e ec i e only o he ex en ha
he cen al bank keeps he in e es a e low (a o below i s neu al le el) o long enough. As
expe ienced du ing he ecen c isis, his policy encoun e s a limi a he ze o (o e ec i e) lowe
bound on he nominal in e es a e; ye , un il such limi ing poin is eached, he policy is gene ally
e ec i e.
Howe e , he policy au ho i ies mus be mind ul o he impac o c edibili y on he coun y’s
IBC. While high c edibili y aises he e ec i eness o mone a y policy, low c edibili y o he e osion
o c edibili y in he eyes o he ma ke s educes i . This ac o is pa icula ly ele an o globally
inancially in eg a ed and la gely indeb ed coun ies, especially i hei capaci y o sus ain a low
in e es a e policy is doub ed by he ma ke s. This would be he case i pe sis en ly low in e es a es
ende ed he economy’s public deb una ac i e o in es o s o i he excess money balances injec ed
by he cen al bank o pu chase (mone ize) he ou s anding deb we e used o buy specula i e asse s
and asse s denomina ed in o eign cu encies. In his case, he au ho i ies would ha e o undo he
s imulus and aise he in e es a e so as o hal exchange a e dep ecia ion, o he wise dep ecia ion
and in la ion would go unchecked. Reusing Eq. (15), a e se ing ∆𝑒𝐷,𝑡
𝑃𝐷,𝑡= 0 and ∆𝑏
�
�
�
�
𝐷,𝐻,𝑡= 0, gi es
(16) ∆𝑋𝐷,𝑡=𝑋𝐷,𝑡− 𝑋𝐷,𝑡−1=
Χ1��𝜄−1�∑�𝜷𝑫,𝒕|𝝎𝒕𝟏�𝑛
∞
𝜏=𝑡 �𝑠𝐷,𝑡+∆𝑀
�
�
�
�
�
𝐷,𝑡
𝑃𝑡�
𝐵𝐷,𝑡−1+∆𝐵
�
�
�
�
𝐷,𝑡�− 𝑖𝑁
𝐵𝑗�∆𝑖𝑡𝐵𝐷+�𝜄−1�∑�𝜷𝑫,𝒕|𝝎𝒕𝟏�𝑛
∞
𝜏=𝑡 �𝑠𝐷,𝑡+∆𝑀
�
�
�
�
�
𝐷,𝑡
𝑃𝑡�
𝐵𝐷,𝑡−1+∆𝐵
�
�
�
�
𝐷,𝑡�− 𝑖𝑁
𝐵𝐷�∆𝜷𝑫,𝒕�= 0
which again shows ha , based on he new in o ma ion se , i coun y D’s c edibili y d ops o a
c i ical le el 𝛽𝐷,𝑡|𝜔𝑡1 (ma ked in bold and ed in Eq. (16)), which neu alizes he e ec o mone a y
s imulus ∆𝑚
�
�
�
�
�
𝐷,𝑡 on he nominal in e es a e, ∆𝜄−1( ∙ )= 0, and hence on eal ou pu , while he la ges
pa o he e ec would dissipa e in o nominal exchange a e dep ecia ion and highe in la ion ia Eq.
22
(14).23 The nega i e c edibili y e ec migh e en ha e a ne con ac iona y impac on ou pu (Fig.
1b).
Finally, i he cen al bank and go e nmen coo dina ed hei ac s and enginee ed a mone a y
inancing o new deb issuance aimed o suppo iscal s imulus ∆𝑏
�
�
�
�
𝐷,𝐶𝐵,𝑡=∆𝑚
�
�
�
�
�
𝐷,𝑡 la ge enough o
keep 𝑖𝑡𝐵𝑗−𝑖𝑁
𝐵𝑗=𝑐𝑐𝑙𝑠𝑡 (a.k.a. "helicop e money"), by o ally di e en ia ing Eq. (8) he change in
he eal ou pu gap would be
(17) ∆𝑋𝐷,𝑡=𝑋𝐷,𝑡− 𝑋𝐷,𝑡−1=𝑋1�𝑖𝑡𝐵𝐷−𝑖𝑁
𝐵𝐷�∆𝑖𝑡𝐵𝐷 + 𝑋2�𝑒𝐷,𝑡
𝑃𝐷,𝑡�∆𝑒𝐷,𝑡
𝑃𝐷,𝑡+𝑋3 ∆𝑏𝑚
�
�
�
�
�
�
𝐷,𝑡=𝑋3 ∆𝑚
�
�
�
�
�
𝐷,𝑡,
since ∆𝑖𝑡𝐵𝑗= 0 by cons uc ion and ∆𝑒𝑗,𝑡= 0 wi h ull pass- h ough om Eq. (14). Eq. (17) shows
ha , by keeping he in e es a e di e en ial cons an , no nega i e e ec s e o i on eal ou pu ; as a
esul , he iscal-mone a y impulse is unencumbe ed, and he policy p og am can be calib a ed o
s abilize eal ou pu a ull capaci y wi hou causing in la iona y p essu e. 24I he s imulus we e
empo a y, and he pass- h ough less han comple e, he nominal exchange dep ecia ion ha would
ollow he empo a y excess supply o money (Eq. (14)) would ampli y he s imulus (Eq. (8)). On he
o he hand, unde a pe sis en mone a y inancing o he iscal de ici s, he ongoing excess money
c ea ion would a ec he nominal exchange a e and he in la ion a e, causing c edibili y o d op, he
ERPT e ec o inc ease (Eq. (5)), and he exchange a e and in la ion o u he ise (Eq. (14)). Thus,
while policy coo dina ion may achie e he bes esul possible, i is no by i sel su icien o he
23 Fo ull neu aliza ion o be possible, ha is, o ∆𝑋𝐷,𝑡= 0, he decline in c edibili y mus o se he
impac ha he mone a y s imulus exe s h ough he change in he p ice o bond B ( ep esen ed by he e m in
pa en heses o he exp ession o ∆𝜄−1( ∙ )), so ha ∆𝜄−1( ∙ )= 0.
24 This esul is consis en wi h Bui e ’s (2016) conclusion ha «helicop e money always wo ks» Howe e ,
he mone a y au ho i ies should always conside he impac o hei ac ion on he exchange a e.
23
coun y o gain c edibili y in he eyes o he ma ke . In ac , he p ospec s o a pe sis en excess
money c ea ion policy would weaken c edibili y in he eyes o he ma ke s.
The analysis o he wo cases abo e shows ha he e ec i eness o mac oeconomic policies
depends on he le el o go e nmen policy c edibili y as pe cei ed by he ma ke s. In pa icula , a
lowe le el o c edibili y, he policy space a ailable o he policy au ho i ies o expansiona y
measu es may be e y limi ed, nihil o e en nega i e, e en in he con ex o loa ing exchange a es.
In pa icula , Eq.’s (14)-(17) poin o he ele ance o a) c edibili y o policy e ec i eness
and p ice dynamics in a con ex whe e economies a e open and globally inancially in eg a ed in he
global ma ke s, and b) he dissipa ion o he policy e ec s in o in la ion. Policy c edibili y c ea es
space o ac i e, e ec i e and non-in la iona y mac o policies. The abuse o such space, howe e ,
dissipa es he policy e ec s in o exchange a e dep ecia ion and highe in la ion. In la ion is he
measu e o he dissipa i e e ec .
As discussed in Sec ion 5 and suppo ed by e idence in Sec ion 6, he e is no mechanical
co espondence be ween changes in go e nmen liabili ies (money and/o deb ), he exchange a e,
in la ion and eal ou pu . The co espondence is coun y speci ic as i depends on he coun y’s
c edibili y as pe cei ed by he ma ke s (Fig. 2) and may change depending on he go e nmen e o s
(o lack he eo ) o gain c edibili y in he eyes o he ma ke s.
24
No e: The esponses o eal ou pu (as a p opo ion o po en ial ou pu ) X/X* o policy shocks
𝑀𝑃𝑀1
and
𝑀𝑃𝑀2
a e
ep esen ed by he wo schedules cha ed in quad an I o Figu e 2 o high-c edibili y
𝐶𝑐𝑢𝑙𝑡𝐶𝑦
𝐻𝐶 and low-
c edibili y 𝐶𝑐𝑢𝑙𝑡𝐶𝑦𝐿𝐶, espec i ely. As discussed in Sec ion 6, he a iable MPI e lec s he combined mone a y
and iscal policy shocks o agg ega e demand. The posi ion o he wo schedules indica es he highe e ec i eness
o policy shocks (in e ms o ou pu changes) in he high-c edibili y coun y. Symme ically, policy shocks a e
ela i ely less e ec i e (in e ms o ou pu changes) in he low-c edibili y coun y, whe e hey dissipa e ins ead
in o highe a es o in la ion. The in la ion esponse 𝑃󰇗 o changes in MPI a e ep esen ed by he wo schedules
cha ed in quad an IV o Figu e 2 o high-c edibili y 𝐶𝑐𝑢𝑙𝑡𝐶𝑦𝐻𝐶 and low-c edibili y 𝐶𝑐𝑢𝑙𝑡𝐶𝑦𝐿𝐶, espec i ely.
The posi ion o he wo schedules indica es he highe dissipa ion o he policy shocks (in e ms o highe
in la ion) in he low-c edibili y coun y. The di e en colo s used o he wo coun ies a e used o ack hei
espec i e ou pu and in la ion esponses o policy shocks, h ough he quad an s.
31
iscal posi ion causes he eal GDP e en o dec ease, a he 1% signi icance le el.31 These esul s
co obo a e PTI P oposi ion 1. No ice ha , based on he es o au oco ela ion and a he 5%
signi icance le el, he null hypo hesis can be ejec ed a o de 1 bu no a highe o de s.
31 In he LC coun ies, a uni pe cen change in public deb leads, on a e age, o an opposi e sign change in
Real GDP o almos 0.46%.

32
The policy e ec i eness no ed in he HC coun ies is associa ed wi h he inding ha , a he 1%
signi icance le el, g owing public indeb edness causes in la ion o dec ease (Table 6).32 These esul s
may be hea ily a ec ed by he global inancial c isis du ing he pe iod obse ed, when he s ong
po olio p e e ences wo ldwide o high-quali y public deb s has a exceeded hei supply, leading
ou pu and in la ion o decline. On he o he hand, mac o policies seem no o ha e any di ec e ec
32 No e ha in he HC coun ies, a uni pe cen change in public deb leads, on a e age, o an opposi e sign
change in in la ion o almos 0.29%. Mac o policies do no a ec in la ion. Only he coe icien o M0 is
posi i e a he 10 pe cen signi icance le el, whe eby a uni pe cen change in mone a y policy would lead, on
a e age, o a same-sign change in in la ion o abou 0.48%.
33
on in la ion in LC coun ies (Table 7) whe e he ecessiona y impac p e ails o g owing public
indeb edness on ou pu . These esul s a e consis en wi h PTI’s P oposi ion 2. No ice ha , based on
he es o au oco ela ion, he null hypo hesis can be ejec ed a i s o de , bu no a a highe o de .
34
7. REFLECTIONS ON THE PTI
When he s ocks o cen al bank money o public deb g ow, somebody has o hold hem willingly o
hei alue o be s able. I money o deb a e issued by a HC coun y – especially i he coun y
happens o be he issue o an in e na ional ese e cu ency – he public wan s o hold hem, ma ke s
make he go e nmen ’s IBC elas ic, and he ela i e p ice o he s ocks is no much pe u bed, i a
all. In ac , in c isis si ua ions, hose s ocks migh e en be in highe demand, om bo h esiden and
non- esiden agen s, and hei p ice would hus inc ease. A he opposi e side, when money o deb
a e issued by a LC coun y, he public migh no necessa ily wan o hold hem, ma ke s make he
go e nmen ’s IBC mo e igid, and he ela i e p ice o he s ocks would hus decline. Now, while a
empo a y inc ease o bo h money and deb could be e ec i ely used as a s opgap measu e e en in
LC coun ies su e ing om ecession (i.e., he helicop e money case discussed ea lie ), a pe sis en
35
deb – such as o inance s a e de ici spending in an a emp o keep ou pu a ull employmen –
would e en ually be unsus ainable: especially unde s ong in e na ional inancial in eg a ion, he
pe spec i e o an inde ini e g ow h (and accumula ion) o he money and deb s ocks would induce
po olio e-composi ions away om hose s ocks and would dep ess hei p ices. As he esul s
discussed in he p e ious sec ion sugges , he economy would mo e a he a a om i s ull-
employmen ou pu le el.
In p inciple, no economy is immune om he "s ock" s o y abo e, al hough, as no ed, HC
coun ies and especially coun ies issuing in e na ional ese e cu encies ( ypical is he case o he
US and Japan) enjoy much g ea e space han o he coun ies: hei IBC is much mo e elas ic and so
he c i ical poin (beyond which hey would s a con on ing unsus ainabili y p oblems) lies much a
ahead han o LC coun ies.33
The IBC elas ici y would depend no jus on domes ic ci cums ances, bu e y much on global
de elopmen s as well. Fo ins ance, in he case o non-idiosync a ic shocks ha would hi he global
economy a la ge, he wo ld demand o asse s denomina ed in in e na ional ese e cu encies would
inc ease independen ly o he domes ic economic condi ions o he issuing coun ies. Such highe
demand would de e mine an e en mo e elas ic IBC o hese coun ies and g an hem s ill la ge
policy space han unde no mal ci cums ances, wi h opposi e exac ly holding o less c edible
coun ies.
In e es ingly, no only he PTI emphasizes he c i ical ole o public liabili ies a he co e o
esou ce alloca ion a he coun y le el; i p o ides a o midable a ionale and an e ec i e ool o
unde s and how na ional public liabili ies a e in luenced by global ac o s and choices in he con ex
33 As no ed al eady (see oo no e 5), he concep o sus ainabili y is he e unde s ood b oadly and encompasses
no only he deb epaymen capaci y o he S a e, bu also he s abili y o he in e nal and ex e nal alue o he
na ional cu ency.
36
o highly in e na ionally inancial in eg a ed economies. Said di e en ly, in such a con ex he ac o s
in luencing he alue o he public liabili ies o any coun y canno be gauged ou side o a global
pe spec i e, which he PTI enables o inco po a e in o he analysis.
8. CONCLUSIONS
This s udy s a ed om wonde ing why mac o policies can be highly e ec i e in some coun ies and
ou igh ine ec i e in o he s, and o wha ex en a coun y s ands o bene i om eco e ing he
economic policy so e eign y i had delibe a ely su ende ed by submi ing i sel o some ex e nal
cons ain s (e.g., joining a mone a y union). The Po olio Theo y o In la ion (PTI) de eloped in
Bossone (2019), and e isi ed and p elimina ily es ed in his s udy, analyzes how he e ec i eness
o mac oeconomic policy in open and globally inancially in eg a ed economies is in luenced by
global in es o decisions, and shows ha when an economy is hea ily indeb ed and is pe cei ed by
he ma ke o be poo ly c edible, in es o s hold i o a igh e in e empo al budge cons ain and
policies aimed o s imula e ou pu g ow h dissipa e in o domes ic cu ency dep ecia ion and highe
in la ion, wi h limi ed o no impac on ou pu . The PTI shows, on he o he hand, ha ma ke s a o d
highly c edible economies much g ea e space o ac i e mac o policies ha can be e ec i e on eal
ou pu and nonin la iona y o e all. The s udy has o e ed some p elimina y co obo a ing e idence.
Th ee ea u es make he PTI especially i as a heo y o in la ion in oday’s global inancial
con ex . One is ha , acco ding o he PTI, he e is no hing mechanical abou he ansmission channel
unning om go e nmen liabili ies o in la ion dynamics: he ansmission es s undamen ally on
he ole o inancial ma ke expec a ions, pe cep ions, and con en ional belie s – as e ealed by
global in es o s h ough hei po olio choices – ega ding he policy c edibili y o a coun y and he
u u e sus ainabili y o i s liabili ies. The second ea u e is ha , acco ding o he PTI, he e ec o
public liabili ies on in la ion is no di ec bu i is media ed by he exchange a e: in es o po olio
choices impac , i s , he exchange a e o he domes ic cu ency as a ela i e p ice o he asse s ha

37
a e aded in e na ionally and in luence domes ic in la ion once he changes in he exchange a e a e
ansmi ed o domes ic p ices ia he passed- h ough and ela i e p ice adjus men mechanisms.
Howe e , he PTI does no ule ou di ec e ec s o ou pu changes on in la ion. Finally, he PTI is
al e na i e o he con en ional "demand-pull" and "cos -push" (s uc u alis ) heo ies o in la ion: as
i s name sugges s, in la ion ollows om he op imal ( e)composi ion o coun y liabili ies wi hin
global in es o po olios. Changes in domes ic p ices a e he consequence o changes in he quali y
o hose liabili ies as hey a e pe cei ed by he ma ginal in es o s.
The PTI p edic ions and esul s shown abo e would lead o d aw a e y basic and ye
ex emely powe ul piece o policy ad ice: while in eg a ing a coun y economy in o he global
sys em deli e s impo an economic bene i s o i s ci izens, na ional policymake s should be ca e ul
ha he economy’s public indeb edness (including ex e nal as domes ic deb ) be always kep a low
le el and unde s ic moni o ing: he la ge he s ock o he o al public liabili ies o an
in e na ionally highly in eg a ed economy, he highe i s deg ee o su ende o na ional policy
so e eign y o ex e nal o ces and in e es s.
38
REFERENCES
Ahumada, V. M. C. (2009), "The Sho -Te m E ec s o Fiscal Policy in Mexico: An Empi ical
S udy," Es udios Económicos, El Colegio de México, Cen o de Es udios Económicos, ol. 24(1),
pages 109-144.
A ellano, M., and S. Bond (1991), "Some es s o speci ica ion o panel da a: Mon e Ca lo e idence
and an applica ion o employmen equa ions," Re iew o Economic S udies. 58 (2): 277.
Backus, D, and E. J. D i ill (1985a), "In la ion and Repu a ion," Ame ican Economic Re iew, Vol.
75 (June), 530-538.
Backus, D, and E. J. D i ill (1985b), "Expec a ion and Policy C edibili y Following a Change in
Regime," Re iew o Economic S udies, Vol. 52 (Ap il), 211-21.
Blancha d, O. (2016), "The US Phillips Cu e: Back o he 60s?," Policy B ie No. PB16-1, Pe e son
Ins i u e o In e na ional Economics, Janua y.
Bossone, B. (2019), Jou nal A icle "The po olio heo y o in la ion and policy (in)e ec i eness,"
Economics, No. 2019-33, June 04.
Bui e , W. H. (2016), "The Simple Analy ics o Helicop e Money: Why I Wo ks — Always,"
Economics, Vol. 8, 2014-28, 21 Augus .
Came on, A. C., and P. K. T i edi, (2009), Mic oeconome ics using S a a, e ised edi ion,
S a aCo p LP.
Chen, Z. and Z., Lei (2015), "Back o he Beginning: Does In es o Di e si ica ion A ec he Fi m's
Cos o Equi y?" 9 Oc obe , a ailable a SSRN: h ps://ss n.com/abs ac =2538386 o
h p://dx.doi.o g/10.2139/ss n.2538386.
Ve nengo, M., and E. Pé ez Calden ey (2019), "Mode n Money Theo y (MMT) in he T opics:
Func ional Finance in De eloping Coun ies," Wo king Pape , Poli ical Economy Resea ch Ins i u e,
Uni e si y o Massachuse s Amhe s , 25 Sep embe .
39
APPENDIX 1. SOLUTION OF THE ECONOMY’S MODEL
Using he Bellman’s equa ion o sol e plan (10)-(13) in he main ex ,
(A1) 𝑉(𝑦𝐻,𝑡,𝑊𝐻,𝑡) = 𝑀𝑀𝑀�𝑢(𝑊𝐻,𝑡 ) + 𝛽𝑉(𝑦𝐻,𝑡+1,𝑊𝐻,𝑡+1 )𝛾𝑡+1
′𝑅𝑡+1
′�,
whe e 𝑅′is he ec o o eal income g ow h a es, eal in e es a es and loss a ios o all bonds,
leads o he Eule equa ion
(A2) 𝑢′(𝑊𝐻,𝑡 ) = �𝛽𝐻,𝑡|𝜔𝑡�𝑙𝐸𝑡�𝑢′(𝑊𝐻,𝑡+𝑁)𝛾𝐻,𝑡+𝑁
′𝑅𝑡+𝑁
′�,
which de e mines he op imal in e empo al pa h o weal h W. Fo a gi en W in each pe iod, hen,
in es o H’s op imal po olio co esponds o he op imal in a-da e alloca ion o W ac oss he a ious
asse s a ailable, and is de i ed by equa ing he ma ginal u ili ies o M and B holdings, each weigh ed
wi h he in e se o i s own p ice:
(A3) 𝑢′�𝑀𝐻,𝐷,𝑡�=𝑢′�𝑀𝐻,𝐹,𝑡�=1
𝑃𝑡𝐵𝐷𝑢′�𝐵𝐻,𝐷,𝑡�=1
𝑒𝑡𝑃𝑡𝐵𝐹𝑢′�𝐵𝐻,𝐹,𝑡�.
Sol ing he model simul aneously o all demand and supply ela ions, unde well-beha ed
in es o p e e ences and op imal iscal and mone a y policies, and wi h ull ERPT e ec ,
ins an aneous ela i e p ice adjus men o he exchange a e, and a gi en p ice le el o coun y F,
op imal po olio alloca ions �𝑀𝐷,𝐻
∗,𝑀𝐹,𝐻,
∗𝐵𝐷,𝐻
∗,𝐵𝐹,𝐻
∗� a ain a equilib ium asse p ices 𝑃𝑡𝐵𝐷∗,𝑃𝑡𝐵𝐹∗ = 1
(since bonds ade a hei con ac ual alue), in e es a es 𝑖𝑡+𝑁
𝐵𝑗∗=𝑖𝑁
𝐵𝑗 (equal o hei neu al le el),
and exchange a e 𝑒𝑡∗, whe e he eal ou pu gap is balanced and he domes ic and wo ld p ice le els
(exp essed in uni s o he domes ic cu ency) a e each equal o 𝑒𝑡∗𝑃𝐹,𝑡
∗. In ac , he closu e o he
ou pu gap depends ul ima ely on he op imali y and e ec i eness o bo h iscal and mone a y
policies, and op imali y calls in o ques ion he issue o coo dina ion be ween iscal and mone a y
policies. While policy e ec i eness will be discussed in he nex subsec ion, op imali y will no be
u he elabo a ed in his s udy.
40
Assuming 𝑢(𝑊)=ln (𝑊), using Eule equa ion (15), eplacing 𝑀𝐻,𝐷,𝑀𝐻,𝐹,𝐵𝐻,𝐷, and 𝐵𝐻,𝐹
wi h hei espec i e eal alues all exp essed in he domes ic cu ency,34 simpli ying and eplacing
he solu ion o Eq. (15) in o Eq. (16), yield equilib ium ela ionship
(A4)
�𝛽𝐻,𝐷,𝑡|𝜔𝑡�𝑛(1−𝑝𝑡+𝑛
∗)𝑛
𝑀𝐻,𝐷,𝑡+𝑛,
∗=�𝛽𝐻,𝐹,𝑡|𝜔𝑡�𝑛(1−𝑝𝑡+𝑛
∗)𝑛
𝑒𝑡∗𝑀𝐻,𝐹,𝑡+𝑛
∗= �𝛽𝐻,𝐷,𝑡|𝜔𝑡�𝑛�1+𝑖𝑡+𝑛
𝐵𝐷∗�𝑛(1−𝑝𝑡+𝑛
∗)𝑛
𝐵𝐻,𝐷,𝑡+𝑛
∗=
�𝛽𝐻,𝐹,𝑡|𝜔𝑡�𝑛�1+𝑖𝑡+𝑛
𝐹∗ �𝑛(1−𝑝𝑡+𝑛
∗)𝑛
𝑒𝑡∗𝐵𝐻,𝐹,𝑡+𝑛
∗,
whe e p is he wo ld a e o in la ion used by he global in es o s o gauge he eal alue o hei
weal h. Re-exp essing Eq. (16) in e ms o he equilib ium nominal exchange a e a ime 𝑡 and
d opping he subsc ip H gi e
(A5) 𝑒𝑡∗=𝛽𝐹,𝑡|𝜔𝑡
𝛽𝐷,𝑡|𝜔𝑡�1
𝑀𝐹,𝑡+1
∗+ 1
𝐵𝐹,𝑡+,1
∗𝐸𝑡�1+𝑖𝑡+1
𝐵𝐹∗��
�1
𝑀𝐷,𝑡+1
∗+ 1
𝐵𝐷,𝑡+1
∗𝐸𝑡�1+𝑖𝑡+1
𝐵𝐷∗��.
No e om Eq. (A4) ha a low 𝛽𝐷 ela i e o 𝛽𝐹 causes in es o s o hold ela i ely less op imal
amoun s o domes ic money and bonds, and no e om Eq. (A5) ha a la ge "c edibili y gap" o
economy D e sus F (p oxied by 𝛽𝐹
𝛽𝐷> 1) de e mines, ce e is pa ibus, a highe equilib ium nominal
exchange a e e o cu ency D e sus cu ency F.
.34 These a e gi en by wha hese asse s can ac ually buy o hei holde s a wo ld ma ke p ices, ha is,
𝛽𝑒𝑀
𝑃and 𝛽𝑒𝐵𝑃𝐵
𝑃, whe e 𝑒= 1 bo h o 𝑀𝐷 and 𝐵𝐷. Fo he analysis and o mal de i a ion o he u ili y o money
and o he asse s, see Bossone (2014).
47
Venezuela: 𝑀0 was de ined as mone a y base. Da a we e collec ed om he balance shee s o Banco
Cen al de Venezuela (h p://www.bc .o g. e/es adis icas/base-mone a ia ). Balances we e ound o
be exp essed in VEB, he na ional cu ency un il 2008. F om ha yea , he VEF became he
coun y’s legal cu ency. Howe e , on 20 Augus 2018, he VES eplaced he VEF as na ional
cu ency a 1 VES = 100000 VEF exchange a e and 1 VEF = 1000 VEB. Values we e con e ed in o
USD by using he ollowing yea ly a e age exchange a es: un il 2008, To al, Na ional cu ency
uni s/US dolla (VEB/USD); om 2008, ollowing he in oduc ion o he VES as na ional cu ency,
To al, Na ional cu ency uni s/US dolla (VEF/USD). Da a we e collec ed om he Bank o I aly
(h ps:// assidicambio.bancadi alia.i / imeSe ies). Da a on nominal GDP o 2015, 2016, and 2017
we e ob ained om IMF (h ps://www.im .o g/ex e nal/da amappe /NGDPD@WEO/VEN), and da a
on he GDP de la o alues o he same yea s we e ob ained om CEIC
(h ps://www.ceicda a.com/en/indica o / enezuela/gdp-de la o -g ow h).
Coun y clus e s
Equa ions (18)-(19) in he ex we e un on wo clus e s o coun ies using panel da a co e ing he
pe iod 2002-2017. Two clus e s o , espec i ely, "high-c edibili y" (HC) and "low-c edibili y" (LC)
coun ies we e o med based on he combined a ings assigned o each coun y by he h ee majo
a ing agencies, Moody’s, S anda d & Poo ’s, and Fi ch (see Table A1 in Appendix 2). The HC
clus e was o med by selec ing coun ies wi h p ime o high-g ade a ings and comp ises 12
coun ies; he LC clus e was o med by conside ing he 7 coun ies a ed as highly specula i e,
subs an ial isks and ex emely specula i e o in de aul . In o de o o m wo clus e o equal size, 5
coun ies we e added o he LC clus e (Colombia, Mo occo, Sou h A ica, Tu key, and U uguay)
a ed as lowe medium g ade o non-in es men g ade specula i e.
I should be no ed ha each coun y a ing may be subjec o change o e ime. The e o e, in
p inciple, he e olu ion o he a ings o each coun y should be acked in an exe cise like he one
abo e, ins ead o jus aking one sho a he coun y a ings a a poin in ime and conside hese
a ings o emain unchanged o he whole pe iod obse ed: a coun y ha oday belongs o he LC
clus e may no ha e belonged o he same clus e in he pas , o ice e sa. Ye , i any hing, missing
o ack he ac ual coun y a ings h oughou he sampling pe iod makes he es ima ion mo e

48
conse a i e o e all, since, i he wo PTI p oposi ions abo e hold ue, he inclusion in a clus e o a
coun y ha has no con inuously belonged ends o weaken he es ima ed impac o policy shocks on
he dependen a iable(s).
TABLE A1. COUNTRY CLUSTERS
Clus e
Moody's S&P Fi ch
Clus e HC: P ime o High g ade
Aus alia
Aaa
AAA
AAA
Canada
Aaa
AAA
AAA
Denma k
Aaa
AAA
AAA
New Zealand
Aaa
AA
AA
No way
Aaa
AAA
AAA
Qa a
Aa3
AA-
AA-
Singapo e
Aaa
AAA
AAA
Sweden
Aaa
AAA
AAA
Swi ze land
Aaa
AAA
AAA
Uni ed A ab Emi a es
Aa2
AA
AA
Uni ed Kingdom
Aa2
AA
AA
Uni ed S a es
Aaa
AA+
AAA
Clus e LC: Highly specula i e , subs an ial isks, ex emely
specula i e , in de aul , Lowe medium g ade , Non-
in es men g ade specula i e
Angola
B3
B-
B
A gen ina
B2
B
B
Egyp
B2
B
B+
Pakis an
B3
B-
B-
Papua New Guinea
B2
B
B+
S i Lanka
B2
B
B
Venezuela
C
B-
RD
Colombia
Baa2
BBB-
BBB
Mo occo
Ba1
BBB-
BBB-
Sou h A ica
Baa3
BB
BB+
Tu key
Ba3
B+
BB
U uguay
Baa2
BBB
BBB-
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