The portfolio theory of inflation and policy (in)effectiveness revisited: Corroborating evidence

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 This Ve sion is a ailable a : h ps://hdl.handle.ne /10419/210640 S anda d-Nu zungsbedingungen: Die Dokumen e au EconS o dü en zu eigenen wissenscha lichen Zwecken und zum P i a geb auch gespeiche und kopie we den. Sie dü en die Dokumen e nich ü ö en liche ode komme zielle Zwecke e iel äl igen, ö en lich auss ellen, ö en lich zugänglich machen, e eiben ode ande wei ig nu zen. So e n die Ve asse die Dokumen e un e Open-Con en -Lizenzen (insbesonde e CC-Lizenzen) zu Ve ügung ges ell haben soll en, gel en abweichend on diesen Nu zungsbedingungen die in de do genann en Lizenz gewäh en Nu zungs ech e. Te ms o use: Documen s in EconS o may be sa ed and copied o you pe sonal and schola ly pu poses. You a e no o copy documen s o public o comme cial pu poses, o exhibi he documen s publicly, o make hem publicly a ailable on he in e ne , o o dis ibu e o o he wise use he documen s in public. I he documen s ha e been made a ailable unde an Open Con en Licence (especially C ea i e Commons Licences), you may exe cise u he usage igh s as speci ied in he indica ed licence. h ps://c ea i ecommons.o g/licenses/by/4.0/ 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- Please no e: You a e mos since ely encou aged o pa icipa e in he open assessmen o his discussion pape . You can do so by ei he ecommending he pape o by pos ing you commen s. Please go o: h p://www.economics-ejou nal.o g/economics/discussionpape s/2020-2 The Edi o © 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).