Bossone, Biagio
A icle
The po olio heo y o in la ion and policy
(in)e ec i eness
Economics: The Open-Access, Open-Assessmen E-Jou nal
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Sugges ed Ci a ion: Bossone, Biagio (2019) : The po olio heo y o in la ion and policy
(in)e ec i eness, Economics: The Open-Access, Open-Assessmen E-Jou nal, ISSN 1864-6042, Kiel
Ins i u e o he Wo ld Economy (I W), Kiel, Vol. 13, Iss. 2019-33, pp. 1-25,
h ps://doi.o g/10.5018/economics-ejou nal.ja.2019-33
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Vol. 13, 2019-33 | June 04, 2019 | h p://dx.doi.o g/10.5018/economics-ejou nal.ja.2019-33
The po olio heo y o in la ion and policy
(in)e ec i eness
Biagio Bossone
Abs ac
The analysis o open mac oeconomies ypically assumes (implici ly o explici ly) ha
esou ce alloca ion decisions a e aken by domes ic agen s. The Po olio Theo y o
In la ion (PTI) de eloped in his s udy assumes ha some c i ical alloca ion decisions a e
aken by global in es o s and in es iga es how such decisions a ec he e ec i eness o
mac oeconomic policy in open and highly inancially in eg a ed economies. The PTI
adop s a modi ied e sion o he po olio balance app oach o exchange a e de e mina ion
and inco po a es op imal in e empo al choices om global in es o s who alloca e esou ces
in e na ionally based, in e alia, on he pe cei ed policy c edibili y o he na ional
au ho i ies and hei policies. The PTI shows ha when a coun y has low c edibili y and is
hea ily indeb ed, in es o s hold i s economy o a igh e in e empo al budge cons ain and
policies aimed o s imula e ou pu g ow h do in ac dissipa e in o cu ency dep ecia ion and
highe in la ion, wi h limi ed o no impac on ou pu . On he o he hand, high c edibili y
c ea es space o e ec i e and non-in la iona y mac o policies wi h limi ed impac on
nominal a iables.
JEL E31 E4 E5 E62 F31 G15 H3
Keywo ds C edibili y; exchange a e; inancial in eg a ion; global in es o ; in e es a e;
in e empo al budge cons ain ; money, bonds and asse s; pass- h ough
Au ho s
Biagio Bossone, Go e nance on Global Finance, The G oup o Lecce, Lecce, I aly,
[email protected]
Ci a ion Biagio Bossone (2019). The po olio heo y o in la ion and policy
(in)e ec i eness. Economics: The Open-Access, Open-Assessmen E-Jou nal, 13 (2019-33):
1–25. h p://dx.doi.o g/10.5018/economics-ejou nal.ja.2019-33
Recei ed Ap il 15, 2019 Published as Economics Discussion Pape Ma ch 11, 2019
Re ised May 11, 2019 Accep ed May 21, 2019 Published June 4, 2019
© Au ho (s) 2019. Licensed unde he C ea i e Commons License - A ibu ion 4.0 In e na ional (CC BY 4.0)
Economics: The Open-Access, Open-Assessmen E-Jou nal 13 (2019–33)
www.economics-ejou nal.o g 2
“I used o hink ha i he e was einca na ion, I
wan ed o come back as he p esiden o he
pope…Bu now I would like o come back as he bond
ma ke . You can in imida e e e ybody.”
James Ca ille1
1 In oduc ion
Is i ue ha loa ing exchange a es p o ec an economy om he consequences o “sudden
s ops” in capi al lows, and g an i s policymake s g ea e lexibili y in bo h managing demand
and sus aining public deb ? O ha a coun y enjoys mo e iscal space i i denomina es i s deb
in i s own cu ency? And e en mo e so, i i s deb is held by i s esiden s (as opposed o
non esiden s)? Should he e o e coun ies ha a e pa o a ixed exchange a e o cu ency
union a angemen exi he a angemen in he expec a ion ha i would gi e hem mo e eeway
o aise ou pu and employmen ?
As is usual wi h mos ques ions in he ealm o economics, he answe o he abo e ones is,
«i depends…». Answe ing hem equi es, i s , o conside how open and inancially in eg a ed
a e he economies unde in es iga ion – in pa icula , whe he hei public liabili ies ade in he
global ma ke s – and hen o igu e how c edible hei policy au ho i ies, amewo k and
ins i u ions a e in he eyes o he ma ke s whe e hei liabili ies ade.
In ecen con ibu ions I a gued ha a ully inancially in eg a ed economy wi h la ge public
deb and poo policy c edibili y (in he eyes o he ma ke ) would no s and o gain much in
e ms o shock insula ion and policy au onomy om ei he issuing liabili ies in i s own ( a he
han a o eign) cu ency o adop ing a lexible ( a he han ixed) exchange a e egime
(Bossone 2018, 2019a, 2019b). By ex ension, I concluded, a coun y wi h he abo e
cha ac e is ics ha is al eady pa o a ixed exchange a e o mone a y union a angemen
would no bene i much, i a all, om exi ing he a angemen unless and un il i ees i sel o
i s deb bu den and adop s policies ha he ma ke s deem o be c edible: in he in e im o ha
poin , and o a while, he coun y’s space o expansiona y mac o policies would be a he
limi ed (i no nihil).
Key o he abo e conclusion was he assump ion o ull in eg a ion o he economy in o he
global inancial ma ke s, whe e he adjec i e “ ull” means absence o ma ke segmen a ions and
ic ions, implying ha a single and global homogeneous ma ke en i onmen exis s whe e
esiden s and non esiden s ac alike. Upon e lec ion, howe e , I ealized ha inancial
in eg a ion does no need o be “ ull” (as i is no , in eali y) o he abo e implica ions o hold
o any gi en coun y, and ha a “high” deg ee o in eg a ion would in ac be su icien o ha
ex en , whe e “high” means ha he public liabili ies o he 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
_________________________
1 Lead s a egis o he success ul 1992 p esiden ial campaign o hen-A kansas go e no William J. Clin on.
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de ined below) and ii) a e capable o shi capi al in and ou o he coun y in eal ime and a
negligible ansac ion cos s.
High inancial in eg a ion hus unde s ood 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. No ice ha his e ec would be
magni ied by adding o high in eg a ion such ealis ic ea u es as high incidence o ins i u ional
in es men o e domes ic sa ings and la ge concen a ion o domes ic weal h, since bo h con e
g ea e ele ance on ac o i) abo e and i s implica ions o esou ce alloca ion.
The s ong ini ial assump ion o ull in eg a ion can he e o e be elaxed, hus gaining in
ealism. As his s udy will show, ma ke segmen a ions and ic ions (such as, o ins ance,
“home bias” ac o s) as well as he p esence o unexploi ed oppo uni ies om po olio
di e si ica ion, can all be admi ed in he analysis wi hou impai ing i s esul s, since wha
ma e s o he esul s o ob ain is ha he p ices o a coun y’s deb and cu ency be de e mined
by global playe s ac ing as “ma ginal” in es o s (as de ined in he inance li e a u e – see
Sec ion 3) – his is wha ul ima ely de e mines he space a ailable o go e nmen s o use
ac i e mac oeconomic policies e ec i ely.
Consequen ly, i he policy au ho i ies o he abo e poo ly c edible and highly indeb ed
economy ope a ing unde a loa ing exchange a e egime we e o use he mac o le e s ac i ely,
hey would in ac cause capi al o lee he coun y, he nominal exchange a e o dep ecia e, and
domes ic in la ion o ise. Ul ima ely, hey would be o ced o e e se hei cou se o ac ion and
manage he economy simila ly o wha hey would ha e done, had hey commi ed o
main aining a ixed exchange a e ule o s a wi h.
This s udy will explo e wha looks like a new heo y o in la ion, which, as he s udy’s i le
sugges s, will be e e ed o as he “po olio heo y o in la ion” (PTI) o easons ha will be
explained below. Acco ding o he PTI, in a nu shell, in es o s ope a ing in globally in eg a ed
inancial ma ke s alloca e esou ces ac oss na ional economies based on he la e ’s c edibili y.
Thus, when in es o s deem a coun y’s c edibili y o be low, he economy is ied o a igh e
in e empo al budge cons ain (IBC) and he issuance o public sec o liabili ies (in he o m o
money o deb unde any cu ency 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.2 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 lexible IBC allows
ou pu o expand wi h no dissipa i e e ec s on nominal a iables.
The heo y is he e o e consis en wi h – and indeed explains – di e en economic ou comes
de i ing om simila policies adop ed by di e en coun ies, on he basis o he di e en
deg ees o c edibili y ha ma ke s a ibu e o he policy au ho i ies o each coun y and hei
ac ion.
Mo eo e , much be e han he p e ailing heo ies o in la ion, he PTI e lec s he
dominan ole ha global inance plays in de ining he space a ailable o na ional au ho i ies o
open and inancially in eg a ed economies o unde ake ac i e, e ec i e and non-in la iona y
demand managemen policies. Indeed, he PTI may p o e especially ele an o in es iga e he
policy space o small and open economies, in pa icula hose ha a e highly indeb ed, and o
iden i y he ci cums ances whe e (and he easons why) hei ac i e mac o policies a e
_________________________
2 The concep s o c edibili y and excess liabili ies will be cla i ied in Sec ion 3.
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ine ec i e, i espec i e o whe he hei liabili ies a e denomina ed in he domes ic cu ency
and hei exchange a e is lexible.
This s udy is o ganized as ollows. Sec ion 2 ela es he PTI o he exis ing ele an
li e a u e. Sec ion 3 discusses he impo ance o inancial in eg a ion and policy c edibili y in
de e mining he e ec i eness o he nominal exchange a e unde speci ic economic
ci cums ances, as a undamen al p emise o he PTI. Sec ion 4 pos ula es he PTI, p o ides a
o mal ep esen a ion o he heo y and discusses i s main esul s. Sec ion 5 conside s he
s eng hs o he PTI as a heo y o explain in la ion in con empo a y economies. Sec ion 6
concludes he s udy.
2 Rela ions wi h he li e a u e
As he PTI es s essen ially on wo pilla s, e e ence is made in his sec ion o he esea ch ha
is pe inen o each o he wo pilla s and o how he PTI ela es o his esea ch. The pilla s 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.
Conside he i s pilla i s . In he PTI, he exchange a e is de e mined as in he PBA,3
whe e inancial ma ke s c ea e demand o p ede e mined s ock supplies o domes ic and
o eign asse s (such as money and bonds), based on cu en weal h, and asse s a e impe ec
subs i u es. As he PBA, he PTI assumes ha asse s a e pa o he in es o po olios and ha
changes in asse supplies induce in es o s o e-balance hei po olios upon isk- e u n
conside a ions, se ing in mo ion an adjus men p ocess ha in luences he exchange a e ia
demand changes o asse s. The PTI mo es beyond he PBA, howe e , in ha i assumes a
highly in eg a ed wo ld capi al ma ke d i en by in es o s who ac globally and alloca e
esou ces ac oss coun ies based on in e empo al op imiza ion c i e ia (see Sec ions 3 and 4).
The PTI, also, gi es p ominence o go e nmen s’ IBC as one essen ial de e minan o he alue
o na ional public deb s. Fu he mo e, he PTI model de eloped in his s udy encompasses a
cen al ole o money, bo h as a mone a y policy ool and as one o he economy’s asse s.
In as much as he PTI elies on a mic o- ounded model wi h in e empo al decisions, i
d aws inspi a ion on he Mode n Open Economy Mac oeconomics (MOEM).4 Howe e , he
PTI depa s om he la e in some impo an espec s. Fi s , while he MOEM’s main building
block consis s o indi idual coun ies ac ing as in e empo ally op imizing home- esiden
agen s, he PTI cen e s on he ole o “global in es o s” as alloca o s o unds ac oss coun ies.
Second, and ela edly, whe eas he MOEM’s pe spec i e is ha o a coun y acing he es o
he wo ld ha gene a es ex e nal shocks o which he coun y economy adap s, and some imes
eac s o spillo e s om shocks ansmi ed om he coun y (T au wein, 2017), he PTI akes
on he pe spec i e o global in es o s and s udies how he hei po olio choices de e mine
exchange a e and in la ion dynamics and how hey a ec he e ec i eness o coun y
_________________________
3 Fo e e ences, see B anson (1985) and Wang (2009).
4 Obs eld and Rogo (1995, 1996).

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mac oeconomic policies in di e en coun y con ex s. Finally, while he MOEM p o ides a
g and analy ical amewo k o e alua e all ele an aspec s o open mac oeconomies, he
ambi ion o he PTI is con ined o de e mining exchange a e and p ice le el changes in open
and highly inancially in eg a ed economies and o e alua ing he e ec i eness o hei mac o
policies.
In sum, while he analysis o mac o policy e ec i eness ypically assumes implici ly (as in
he case o he PBA) o explici ly (as in he case o he MOEM) ha esou ce alloca ion
decisions a e aken by domes ic agen s, he PTI assumes ha , when coun ies a e in eg a ed in
he global eal and inancial ma ke s, c i ical esou ce alloca ion decisions a e aken by
in e na ional in es o s ac ing on a di e en (global) pe spec i e, and uses his assump ion o
e alua e how hese decisions a ec mac o policy e ec i eness a he coun y le el.
As ega ds he second pilla – on policy c edibili y, he exchange a e and in la ion – he
s udy alls wi hin he s and o esea ch on c edibili y opened by Agéno (1994) and Cal o and
Végh (1991), and u he de eloped by Cal o and Reinha (2002) unde hei “ ea o loa ing”
concep ualiza ion. O he ele an li e a u e in his a ea o esea ch is empi ical in na u e and
co e s bo h he analysis o he pass- h ough e ec om he exchange a e o in la ion and he
ela ionship be ween policy c edibili y and he in ensi y o he exchange a e pass- h ough
(ERPT). On he ERPT e ec , in ligh o he impo ance gi en by his s udy o he openness and
in e na ional in eg a ion o na ional economies, a ele an e e ence o men ion is he wo k by
Benigno and Faia (2016), which, based on US da a, shows and measu es he a ious channels
h ough which globaliza ion (especially in ade) has aised he deg ee o ERPT bo h in he sho
and he long un as a esul o ade openness, g ea e compe i ion, and he inc easing sha e o
o eign p oduc s sold domes ically. Fu he mo e, in 2016 he cen al bank o Sweden ound ha ,
since 2014, in la ion had shown a ising end in he coun y and he dep ecia ion o he k ona
ha had aken place o e he pe iod was deemed o ha e con ibu ed o his de elopmen
(S e iges Riksbank, 2016). Mo e gene ally, howe e , as a s udy om he Bank o In e na ional
Se lemen s has ecen ly ound, while he ERPT e ec in eme ging ma ke economies has
dec eased ollowing he 2008-09 inancial c isis, he e ec in ad anced economies has emained
ela i ely low and s able o e ime (Jašo á e al., 2016). In Canada, whe e exchange a e
mo emen s do ha e a ma e ial impac on he p ices o consume goods, he ERPT e ec has
been shown o ha e only a ansi o y in luence o e he a e o in la ion, since he long- un
in la ion expec a ions a e ancho ed nea he Bank o Canada’s in la ion a ge and hus play a
mi iga ing ole on he pass- h ough (Sa oie-Chabo and Khan, 2015). This a gumen sugges s,
ha policy c edibili y – ce e is pa ibus – weakens he link be ween he exchange a e and
in la ion.5 This causal ela ionship seems o be suppo ed by a numbe o s udies. Aleem and
_________________________
5 While no all coun y s udies on he ERPT e ec may be e iewed he e, some ha co e eme ging ma ke
economies a e wo h men ioning. Zelealem and Musila (2018) examine he empo al ela ionships be ween in la ion
and exchange a e changes, and hei implica ions o he ade balance, and ind ha in he long un a eal
dep ecia ion leads o an inc ease in in la ion. Suleiman e al. (2018) es ima e he quan i a i e e ec s o exchange a e
dep ecia ion on budge de ici and in la ion in Nige ia and ind ha he impac o he exchange a e on in la ion is
posi i e, al hough i is no s a is ically signi ican . Also, a ai ly subs an ial ERPT e ec , al hough incomple e and
slow, has been ound o Egyp by Helmy e al. (2018), who a ibu e he eason o he incomple eness and slowness
o he ci cums ance ha he consume p ice index in Egyp include a ela i ely la ge numbe o subsidized
commodi ies and goods wi h adminis e ed p ices.
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Lahiani (2014) show ha a lowe ERPT is associa ed wi h a c edible mone a y policy aiming a
con olling in la ion and ind e idence ha he EPRT is highe in La in Ame ican coun ies han
in Eas Asian coun ies, whe e i has declined since he adop ion o an in la ion a ge ing
mone a y policy.6 A simila esul was obse ed by Edwa ds (2006) examining eme ging
ma ke economies, and by Takh amano a (2008) analyzing OECD coun ies. Ca iè e-Swallow
e al. (2016) and Lopez-Villa icencio and Mignon (2016) iden i y s ong links be ween he
ERPT and he mone a y policy egime’s pe o mance in deli e ing p ice s abili y in se e al
eme ging economies. This esul is u he co obo a ed by Kabundi and Mlachila (2018) o
Sou h A ica and by Winkel ied (2014) o Pe u. Looking a he B azilian expe ience, Fe ei a
de Mendonça and Tos es (2014) ind ha no only mone a y bu also iscal policy c edibili y
ma e s o educing he pass- h ough on in la ion o ma ke p ices and in la ion expec a ions.
Finally, he esul s o his s udy ega ding he e ec i eness o mac oeconomic policies in
ela ion o he c edibili y o he coun ies unde aking hem a e in line wi h he empi ical
indings by Calde ón e al. (2004), based on a panel o 11 eme ging ma ke economies and ime-
se ies da a o Chile. These indings show ha he cyclical p ope ies o mac oeconomic
policies depend c i ically on policy c edibili y, and suppo he conclusion ha coun ies wi h
highe c edibili y (as e lec ed by lowe coun y isk le els) a e able o conduc coun e cyclical
iscal and mone a y policies, while coun ies wi h less c edible policies ail o do so.
3 Financial in eg a ion, c edibili y and exchange a e
(non)neu ali y
The e ec i eness o he exchange a e as an adjus men mechanism in a gi en coun y depends
c i ically on h ee key a iables (Bossone, 2018). These include he coun y’s deg ee o
inancial in eg a ion in o he global ma ke s,7 he size o i s public deb (i espec i e o cu ency
denomina ion), and i s le el o policy c edibili y.8 To see how hese ac o s in e ac wi h each
o he , le ’s ake a highly inancially in eg a ed coun y, su e ing om weak policy c edibili y,
_________________________
6 In o he wo ds, he mo e c edible he cen al bank, he quicke in la ion e u ns o i s s eady-s a e le el om be o e
i su e ed a shock.
7 As gene ally unde s ood, in a ully in eg a ed inancial ma ke asse p ices would be de e mined compe i i ely,
each coun y and ins i u ion ope a ing in he ma ke would be a p ice ake , and in e es a es (ne o isk p emia)
would be equalized e e ywhe e ac oss ma ke s. Full in eg a ion would co espond o each asse being aded in a
single global ma ke . No ic ions (e.g., home bias ac o s) would lea e a bi age oppo uni ies unexploi ed by agen s
anywhe e in he ma ke s. The absence o ic ions would be somewha elaxed in he con ex o a "high" bu no
necessa ily " ull" deg ee o inancial in eg a ion, as assumed in his s udy and as discussed in Sec ion 1.
8 Based on he app oach in oduced in mac oeconomics by Backus and D i il (1985a, 1985b), 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.).
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and assume ha i s policymake s adop a loa ing exchange a e egime and commi o
expanding public liabili ies (deb and/o money) as much as necessa y o s abilize ou pu and
employmen a ull capaci y. Wi h pe sis en expansion o he public liabili ies, he
policymake s would soon be aced wi h a dilemma:
• hey may ei he be o ced o se he in e es a es on deb liabili ies high enough o p e en
he exchange a e om alling a le els ha would make he liabili ies unsus ainable, o
• hey may decide o mone ize he deb as needed o keep in e es a es low and o gua an ee
deb se ice.
Unde he i s op ion, he coun y would ha e o abandon i s policy objec i e o s abilizing
ou pu o ull-employmen le el, and he esul ing endogenei y o he in e es a e would, de
ac o, amoun o b inging back h ough he window he ixed exchange policy ha was h own
ou o he doo . Unde he second op ion, he coun y would ail o achie e he objec i e
anyway. In ex-an e (equilib ium) e ms, and om he s andpoin o he liabili ies’ holde s, he
wo op ions a e equi alen since he expec ed losses om he isk o deb de aul (as
compensa ed ex an e by highe in e es a e p emia) would equal he expec ed losses om
cu ency dep ecia ion (a o m o de aul o i s own).
Indeed, i he liabili ies consis o public deb denomina ed in a o eign cu ency, in es o s
ace he isk o he coun y de aul ing on i s deb obliga ions a some u u e da e and hus
p o ec hei in es men s by equi ing an app op ia e p emium on he deb in e es a e. On he
o he hand, i deb is denomina ed in he domes ic cu ency, in es o s a e p o ec ed agains he
isk o de aul (since he issue can always mone ize he deb ), ye hey a e exposed o he isk
o u u e cu ency dep ecia ion based on he au ho i ies’ commi men o unbounded deb
mone iza ion. Thus, all else equal, bo h op ions ca y he same p obabili y o igge ing a
con ac iona y sudden s op, and he lexibili y o loa ing exchange a es plays no ole in
in luencing he economy’s eal a iables.
Globaliza ion
A cen al assump ion unde pinning his conclusion is he coun y’s high in eg a ion in o he
global inancial ma ke s, which ends o emo e (bu does no necessa ily emo e en i ely)
sys ema ic di e ences be ween he in e empo al beha io o esiden and non esiden agen s
and be ween hei alua ions o he coun y’s liabili ies, bu mos o all enable i s public
liabili ies o be aded in e na ionally. Unde such condi ion, when aced wi h he p ospec s o
he coun y issuing “excess” liabili ies,9 esiden s and non esiden s alike would eplace a he
_________________________
9 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.
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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. I should be emphasized ha he concep o excess liabili ies he e e e s o a
sus ained issuance o public liabili ies by a poo ly c edible economy, no o he inancing o
sho - un budge a y policies o add ess ansi o y ou pu gaps (see he discussion o he
“helicop e money“ case in Sec ion 4).10
This e ec o high inancial in eg a ion would be u he ein o ced i i) he incidence o
ins i u ional in es men o e o al domes ic sa ings we e high and ii) he dis ibu ion o
domes ic weal h we e la gely unequal (o concen a ed), since bo h ea u es magni y he ole o
global in es o s (see below) in he p ice de e mina ion p ocess o he aded liabili ies. In
pa icula , as exchange a es o en di e ge conside ably and pe sis en ly om pu chasing powe
pa i ies, ins i u ional in es o s and he owne s o la ge weal h a e ypically mo e sensi i e han
small sa e s o he need o p o ec hei asse s no jus om domes ic in la ion bu also om
losses due o exchange a e dynamics. Such in es o s op imize hei po olios by aking a mo e
global iew o asse isks and e u ns han small sa e s, and much mo e easily han small sa e s
can ( e)di ec hei in es men s ac oss global ma ke s. Since such in es o s would ope a e a he
ele an ma gin, hey would de e mine p ices a which ades would be execu ed and se he
benchma ks o o he agen s o de e mine hei own alloca ions choices based on hose p ices
(see Sec ion 4).
I is o en objec ed ha esiden and non- esiden agen s use di e en in la ion a es o gauge
hei po olio choices, wi h esiden agen s being p ima ily in e es ed in p o ec ing hei weal h
om he e osion due o domes ic p ice inc eases and he e o e being less esponsi e o o eign
in la ion. In ac , o he ex en ha p ices a e de e mined by ma ginal in es o s who manage
hei po olios aking a global pe spec i e and a e able o ans e capi al c oss-bo de in eal
ime and a negligible cos s, asse alues would be d i en by he expec ed dynamics o
in e na ional asse p ices. 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 he con a y), and he mo e open is he economy and mo e
lexible i s p ices, he g ea e is he ansmission om he exchange a e o domes ic p ices
( h ough he ERPT e ec ).
These global in es o s ac as “ma ginal” in es o s, ha is, hose who ades a he ma gin
and he e o e ha e he mos in luence on he p icing o hei ades.11 Thus, in poo ly c edible
and highly indeb ed economies highe in la ion could 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. In ac , wi h high inancial in eg a ion, high incidence o ins i u ional sa ings,
and la ge concen a ion o weal h, he issuance o excess liabili ies (as de ined abo e) would
i s p omp a la ge demand o domes ic non-money asse s (e.g., eal es a e) and hen
inc easingly cause capi al ou lows.
Based on he abo e assump ions, hus, he policy space a ailable o a coun y o
expansiona y measu es g ows na owe wi h i s s ock o liabili ies – in whiche e cu ency
_________________________
10 O cou se, esiden 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).
11 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).
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ha ∆𝑋𝐷,𝑡= 0; ye , he iscal s imulus would inc ease he nominal exchange a e and in la ion
ia Eq. (14). 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. 1a).
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
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 cu e 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 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 cu e 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 cu es shi , espec i ely, om EE0 up o EE1and om MM0 backwa d o MM1, and
he FF cu e 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.
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 cu e
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 cu e 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.

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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 1.23 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)).
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 highly inancially in eg a ed and highly 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
𝐵𝐷�∆𝑖𝑡𝐵𝐷+
�𝜄−1�∑�𝜷𝑫,𝒕|𝝎𝒕𝟏�𝑛
∞
𝜏=𝑡 �𝑠𝐷,𝑡+∆𝑀
�
�
�
�
�
𝐷,𝑡
𝑃𝑡�
𝐵𝐷,𝑡−1+∆𝐵
�
�
�
�
𝐷,𝑡�− 𝑖𝑁
𝐷�∆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)) ha neu alizes he e ec o he
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
_________________________
23 This is due o he ac ha hey now hold domes ic money balances in excess wi h espec o op imal balances.
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highe in la ion ia Eq. (14).24 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 a iscal s imulus �∆𝑏
�
�
�
�
𝐷,𝐶𝐵,𝑡=∆𝑚
�
�
�
�
�
𝐷,𝑡�
la ge enough o keep 𝑖𝑡𝐵𝐷−𝑖𝑁
𝐵𝐷=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 gi en by
(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 ∆𝑖𝑡𝐵𝐷= 0 by cons uc ion and ∆𝑒𝐷,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. 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. I 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 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 highly 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 will be discussed in he nex sec ion, 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
_________________________
24 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.
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pe cei ed by he ma ke s 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.
5 Why is a new heo y o in la ion needed?
P e ailing mac oeconomic heo ies ha e been unsuccess ul a explaining in la ion in
con empo a y economies. Old Mone a ism as well as he New Classical school ha e p o en
unable o accoun o how he massi e and pe sis en money injec ions ha we e enginee ed in
ad anced economies du ing he G ea Recession ha e la gely ailed o ekindle in la ion.
Simila ly, New Keynesianism has been unable o explain he e y slow mo ion o low-in e es
a e policies o deli e on he in la ion a ge s p omised by cen al banks (Palley, 2019), and in
ac i has been caugh in lag an con adic ion be ween i s policy p esc ip ions and i s inhe en
heo e ical Neo-Fishe ian s uc u e, which should ha e led o opposi e policy p esc ip ions (see
Coch ane, 2017).25
Mo e ecen ly, he Fiscal Theo y o he P ice Le el (FTPL) has e-asse ed i sel as a
su icien heo y o explain he p ice le el as being de e mined by go e nmen deb and iscal
policy alone, wi h mone a y policy playing a bes an indi ec ole. O iginally de eloped in he
ea ly 1990s, he FTPL has made a comeback in ecen yea s; ye , upon igo ous analysis, i has
been shown o be in e nally inconsis en in suppo ing i s conclusion ha he gene al p ice le el
akes on he alue equi ed o ensu e ha he eal con ac ual alue o he ou s anding s ock o
nominal (non-mone a y) public deb is always equal o he p esen discoun ed alue o he
cu en and u u e eal p ima y su pluses and mone a y inancings o he S a e.26
Wha hese heo ies lea e ou o he pic u e is how policy e ec i eness may change and
a ec in la ion in esponse o in es o s’ di e se a i ude owa d di e en coun ies in a wo ld o
highly open and inancially in eg a ed economies whe e global inancial ma ke s play a
dominan ole in d i ing esou ce alloca ion ac oss na ional bounda ies, based on he pe cei ed
policy c edibili y o each coun y. Whe e c edibili y is low, he space a ailable o using ac i e
demand managemen policies is limi ed and he mos likely esul o such policies is cu ency
dep ecia ion and in la ion, wi h limi ed o no gains on he eal a iables o in e es (ou pu and
esou ce employmen ).
The e is, he e o e, a need o a heo y ha can explain he ine ec i eness o
mac oeconomic policies, and hei in la iona y consequences, aking in o accoun he global
inancial con ex ha has become dominan nowadays. Two c i ical ea u es make he PTI
de eloped in his s udy especially i as a heo y o in la ion in oday’s global 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. The ansmission es s undamen ally on he
_________________________
25 See also he discussions by J. Hend ickson in In De ense o Neo-Fishe ism The E e yday Economis , Oc obe 17,
2014 h ps://e e ydayecon.wo dp ess.com/2014/10/17/in-de ense-o -neo- ishe ism/, and in New Keynesian Failu e,
The E e yday Economis , Augus 20, 2015 h ps://e e ydayecon.wo dp ess.com/2015/08/20/ he-new-keynesian-
ailu e/.
26 See Bui e (2017) and Bui e and Sibe (2018) o a comp ehensi e e iew o he ele an li e a u e, and o he
analysis o he anomalies and inconsis encies o he FTPL.
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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. To illus a e he poin h ough an example, a
coun y ha would expand i s public liabili ies o inance new ou pu and employmen , all else
being equal, could be success ul in i s a emp ( hus ending up wi h highe ou pu a low
in la ion) o unsuccess ul ( hus ending up wi h highe in la ion and limi ed o no change in eal
a iables), depending on how he c edibili y o he coun y’s au ho i ies and policy ins i u ions
as pe cei ed by he ma ke . Whe eas he coun y’s liabili ies would be deemed o be
in e empo ally sus ainable in he o me case, hey would be ega ded as no sus ainable in he
la e , hus leading in es o s o e y di e en po olio alloca ion choices in each case.
Acco ding o he PTI, in ei he e en he ma ke is cen al in de e mining he elas ici y o he
coun y’s IBC, and while in es o s may be assumed o ac a ionally (g ounding hei po olio
choices on he bes knowledge a ailable), he explana o y powe o he heo y does no equi e
hem o be necessa ily igh in hei judgmen s – he heo y simply p edic s ha wha e e
in es o s decide does ul ima ely de e mine he ou come o he coun y’ policies.
The o he 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 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.
In he PTI, he e o e, he inancial and ade sec o s, bo h domes ic and ex e nal, in e ac
s ongly wi h each o he , e lec ing he deg ee o in eg a ion o he economies in o he global
( eal and inancial) ma ke s. The di e en speeds a which such ma ke s p ocess he in o ma ion
a e c i ical o he ansmission o he p ice signals o p oceed om he inancial asse s o he
goods and se ices exchanged in he economy, and back in o he eal alue o he asse s
supplied o he ma ke s and hose held by he in es o s.
An impo an implica ion o he wo c i ical ea u es jus discussed is ha he PTI may
explain how iden ical policies may a ain di e en ou comes in di e en coun ies. Fo ins ance,
ac i e demand managemen policies in poo ly c edible coun ies may ail o s imula e ou pu
and migh ins ead cause in la ion o ise (e en in he p esence o la ge ou pu gaps) and capi al
o lee he economy due o an inelas ic IBC and unancho ed in la ion expec a ions; on he o he
hand, in highly epu ed coun ies wi h mo e elas ic IBC (as de e mined by global ma ke
p e e ences) and s ongly ancho ed expec a ions, he same policies may achie e he desi ed
esul s in e ms o ou pu and eal esou ce use, wi h limi ed o no dissipa i e e ec on he
exchange a e and in la ion.
6 Conclusion
The analysis o open mac oeconomies ypically assumes (implici ly o explici ly) ha esou ce
alloca ion decisions a e aken by domes ic agen s. The Po olio Theo y o In la ion (PTI)
de eloped in his s udy has assumed ha some c i ical alloca ion decisions a e aken by global
in es o s and in es iga es how such decisions a ec he e ec i eness o mac oeconomic policy
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in open and highly inancial in eg a ed economies. Based on his assump ion, he PTI has
in es iga ed he cen al ole o global inancial ma ke s in de e mining he e ec i eness o
mac oeconomic policy in open and highly inancially in eg a ed economies. Using a modi ied
e sion o he po olio balance app oach o exchange a e de e mina ion, he PTI builds on he
ole o global inancial in es o s as agen s ac ing as in e empo al and in e na ional esou ce
alloca o s and ope a ing in a highly in eg a ed wo ld ma ke space whe e hey can mo e capi al
ac oss coun ies quickly and a negligible cos .
Acco ding o he PTI, domes ic in la ion a ies di ec ly wi h he coun y’s c edibili y gap
and wi h changes in he ela i e dynamics o domes ic e sus o eign money and public deb
s ocks, he in e es a e di e en ial, and o eign in la ion. Also, he PTI p edic s ha mone a y
and iscal policies can be e ec i e i he coun y unde aking hem enjoys s ong c edibili y (in
he eyes o he ma ke s), while hey a e less e ec i e o ine ec i e, and e en ually dissipa e
in o cu ency dep ecia ion and highe in la ion, i he coun y unde aking hem is deemed
poo ly c edible. The PTI, he e o e, can explain how iden ical policies may ha e di e en
economic ou comes in di e en coun ies.
The PTI also sugges s ha coo dina ion be ween mone a y and iscal policies is necessa y
bu no su icien o a coun y o gain c edibili y in he eyes o he ma ke .
Mo e b oadly, as a heo y o policy (in)e ec i eness, he PTI poin s o a gene al s a egic
and ye p ac ical conclusion. A coun y ha in ends o main ain o eco e space o he ac i e
use o he mac oeconomic policy le e s may pu sue one o wo al e na i e op ions – one
desi able, he o he one no qui e so. The undesi able op ion would be o he coun y o isola e
i sel om he in e na ional inancial ma ke s and adop a deg ee o domes ic inancial
ep ession ha would o ce i s esiden s o hold all he liabili ies (money and deb ) ha i issues.
The supe io op ion would be o he coun y o in eg a e i sel in he global inancial sys em
bu , also, o ca e ully p e en i s s ock o liabili ies om g owing ino dina ely la ge (in o he
wo ds, i should keep he public deb low), hus a oiding ha ing o su ende i s policy
so e eign y o he inancial ma ke s.
Finally, be e han p e ailing heo ies o in la ion, he PTI can e lec he dominan ole o
global inance in de ining he space a ailable o na ional au ho i ies o open and inancially
in eg a ed economies o unde ake ac i e, e ec i e and non-in la iona y demand managemen
policies.
Acknowledgemen I would like o hank he wo anonymous e e ees o his s udy, who p o ided me
wi h e y aluable commen s and sugges ions on ea lie e sions o i . I also would like o hank La y
Summe s o his hough -p o oking commen s on issues ela ing o he opic o he s udy, Cha les
Wyplosz o his help ul insigh s a an ea lie s age o my e lec ion on i , and An onio Fa as o inspi ing
my conside a ion o policy e ec i eness unde loa ing exchange a es. I am in ellec ually indeb ed o he
wo k o Willem Bui e , mo e han he e e ences o his publica ions by hemsel es e eal. Ob iously, I
am he only esponsible o he iews exp essed in he s udy and o any emaining e o s. Finally, I am
g a e ul o my wi e O nella o he un emi ing suppo .

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Appendix 1. Solu ion o he 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,𝑗,𝑡|𝜔𝑡�𝑛𝐸𝑡�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 p ice o each:
(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 comple e ERPT,
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 �𝑀𝐻,𝐷
∗,𝑀𝐻,𝐹
∗𝐵𝐻,𝐷
∗,𝐵𝐻,𝐹
∗� 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.
Assuming 𝑢(𝑊)= ln (𝑊), using Eule equa ion (A2), 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,27 simpli ying and
eplacing he solu ion o Eq. (A2) in o Eq. (A3), 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
∗,
_________________________
27 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 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).
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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. (A4) 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 F.
Finally, ans o ming Eq.’s (4) in he main ex and (A5) using na u al loga i hms,
subs i u ing Eq. (A5) in o Eq. (4) in he main ex , applying Taylo ’s expansion o de i e he
equali y ln(1 + 𝑖)≈ 𝑖,28 and sol ing o he a e o domes ic in la ion, yield:
(A6) 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( ∙ )�,
which is epo ed as Eq. (14) in he main ex .
_________________________
28 F om Taylo ’s expansion, ln(1 + 𝑖) = 𝑖−𝑖2
2+𝑖3
3−𝑖4
4+𝑖5
5−⋯ = ∑(−1)𝑙+1 𝑖𝑙
∞
𝑙=1 , ∀ 𝑖∈(−1, 1], and
lim𝑙→∞(𝑅𝑙)=−𝑖2
2+𝑖3
3−𝑖4
4+𝑖5
5−⋯=(−1)𝑙
(1+𝜉)𝑙+1
(𝑖)𝑙+1
(𝑙+1)!= 0 , ∀ 𝜉∈(0, 𝑖), and ∀𝑖∈(−1, 1]. Thus, ln(1 + 𝑖)≈𝑖.
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