The portfolio theory of inflation and policy (in)effectiveness: a revisitation

ABSTRACT

This article revisits the Portfolio Theory of Inflation (PTI), with a view to further articulating its findings and implications. The article adds to the micro-foundations of the PTI, framing more rigorously the role of global investors as international allocators of capital resources, and providing richer analysis of their interaction with macroeconomic policies at country level. The article explores how country credibility enters the capital allocation choice process of global investors and how global investor choices shape the space available to country policy making, determining the extent to which the effect of macro-policies dissipates into exchange rate depreciation and higher inflation.

KEYWORDS:

• Credibility
• exchange rate
• financial integration
• global investor
• inflation
• intertemporal budget constraint
• money and bonds
• assets and liabilities
• pass-through

JEL:

• E31
• E4
• E5
• E62
• F31
• G15
• H3

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1. I am hugely grateful to the anonymous referee of this journal for the very helpful comments and suggestions provided to me across the various draft revisions. I would not have been able to realize my intent to revisit, and improve on, my Portfolio Theory of Inflation, without being induced to ponder on and respond to her/his critical and yet very constructive remarks. I am not sure I was eventually able to convince him/her of the goodness of the approach I propose, but the quality of my article has benefitted greatly. My intellectual indebtedness goes to Willem Buiter and Charles Wyplosz for inspiring me on the importance of intertemporal consistency in the analysis of macroeconomic policy choices and credibility as a factor determining macro-policy effectiveness. Obviously, I remain the only responsible for the opinions expressed in the article and for any remaining errors. As always, I thank my wife Ornella for her unremitting support.

2. See Bossone (2019, 2020a, 2020b).

3. The expression “policy space” here refers to the margin of action policymakers can use to conduct expansionary fiscal and monetary policy actions before these actions threaten the sustainability of public sector liabilities and/or before measures become necessary to ensure such sustainability.

4. For relevant references on MMT, see Wray (2015).

5. For a study on the marginal investor and a review of the marginal investor in the finance literature, see Bartholdy and Kate (2004) and references therein reported, and see more recently Chen and Lei (2015).

6. The words “tighter“ and “less stringent“ should not be confused with ”harder” and ”softer” as they apply to the concept of budget constraint. While harder and softer refer to the extent to which a budget constraint is binding on an agent, tighter and less stringent refer to the quantitative limit imposed by a budget constraint on an agent (e.g. how high or low the limit on the budget deficit is set relative, say, to GDP): a hard constraint may become less stringent but could still remain hard. Thus, in the case of a government, tighter and less stringent indicate how much space overall is available to the government for its policy actions.

7. Specifically, the areas where this article improves on the original formulation of the PTI include: i) the role of global investors as links between the micro and macro side of the economy’s model, and hence between capital allocation choices and a country’s macro-policy space; ii) the formalization of the global investor’s inter-temporal and intra-temporal optimal plan; iii) the treatment of the asset utility function; iv) the separation between the rate of time preference and the country credibility factor (which had originally been conflated into one single term); v) the treatment of the risk of losses on assets; vi) the stock-flow consistency between global investors’ capital allocation choices and public sector liabilities; vii) the structure of world and domestic price deflators; viii) real output growth; ix) the policy objective function of the central bank; and x) the analysis of the exchange rate and inflation implications of macro-policies. Finally, some of the equations were revised and errors and typos corrected.

8. This ratio generally varies between 0 and a value less than 1. Following the Global Financial Crises, however, cases were observed where the value of the ratio exceeded 1. These are cases where some assets (typically bonds issued by highly reputed governments) are considered by the markets to be especially safe, and trade at prices above their contractual value, thereby earning negative yields (see Why do investors buy negative yield bonds?, Financial Times, 12 April 2006). In such cases, private creditors of the issuing governments are de facto turned into private debtors.

9. For the literature on the ERPT and credibility, see references in Section 2 of Bossone (2019).

10. This simplifying assumption is justified since the study focuses on aggregate demand and not on the real sources of output growth. Incorporating a properly structured dynamic supply function is a possible extension of PTI analysis.

11. While including the modelling of deficit and surplus agents would enrich the model, it would not change its results. What is being studied here is the allocation decisions of global investors, while the behaviour of deficit/surplus units is not central to the analysis.

12. In other words, these agents liquidate (part of) their investment to finance current consumption. If they divest funds to re-invest them, their net effect on global investor H’s portfolio is zero ($\mathrm{\Delta }{W}_H=0$).

13. If $P^Q$is the price of a bond or a given stock, changes in $P^Q$ correspond to capital gains or losses on asset Q.

14. The introduction of the risk of loss is an innovation on my original assets-in-the-utility function approach.

15. Unlike what the anonymous reviewer has noted, Equation (13) does not suffer from overdetermination of policy variables; it rather deliberately reflects a degree of indetermination, which can only be resolved within each specific country context, once investor expectations are known, based on their perceptions of country policy credibility. This reflects the nature of the PTI, whose underlying approach, as I have noted in my previous works, is not mechanistic in that it derives the inflationary and real output consequences of specific policy actions according to country circumstances: the very same policy actions would have different impacts depending on different levels of country policy credibility (as perceived by global investors).

16. Note that if asset Q is cash, or M, then $P^M=1$, $i^M=0$, $l^M=0$, ${\xi }^M=0$, and $R^M=-p$. In fact, the introduction of a central bank digital currency for general purpose usage (that is, digital cash) would allow for $i^M\stackrel{\stackrel{>}{\text{relbar}\phantom{{ }_x}}}{<\phantom{{ }_x}}0$, whereby the central bank would have the possibility of applying positive or negative interest rates on cash.

17. In force of the inverse relationship between bond prices and the interest rate on bonds, equilibrium bond returns $R_t^{B_D^{\ast }}$ and $R_t^{B_F^{\ast }}$ are simultaneously determined with bond prices $P_{D,t}^{B\ast }$ and $P_{F,t}^{B\ast }$.

18. Applying Taylor’s expansion, $\mathrm{l}\mathrm{n}\left(1+\chi \right)=\chi -\frac{{\chi }^2}{2}+\frac{{\chi }^3}{3}-\frac{{\chi }^4}{4}+\frac{{\chi }^5}{5}-\dots =\sum _{n=1}^{\mathrm{\infty }}{\left(-1\right)}^{n+1}\frac{{\chi }^n}{n}$, $\mathrm{\forall }\chi \in \left(-1,1\right]$, and $\underset{n\to \mathrm{\infty }}{lim}\left(R_n\right)=-\frac{{\chi }^2}{2}+\frac{{\chi }^3}{3}-\frac{{\chi }^4}{4}+\frac{{\chi }^5}{5}-\dots =\frac{{\left(-1\right)}^{\mathrm{n}}}{{\left(1+\zeta \right)}^{\mathrm{n}+1}}\frac{{\left(\beta \right)}^{\mathrm{n}+1}}{\left(\mathrm{n}+1\right)!}=0$, $\mathrm{\forall }\zeta \in \left(0,\chi \right)$. Thus, $ln\left(1+\chi \right)\approx \chi .$.

19. Notice that the rate of change of bond prices has been dropped from the calculation of the rate of return on the bonds since the inverse relationship between the price of a bond and the interest rate on the bond makes one of the two variables redundant.

20. Notice here that, from the perspective of each reserve-issuing country the subscripts D and F in Equation (22) would be inverted, with the reserve-currency country being domestic (D) and the other countries being foreign (F).

21. As noted in Section 2, this result points to the relevance of using world price indicators as deflators when operating from a global (as against local) investment perspective.

Additional information

Notes on contributors

Biagio Bossone

Biagio Bossone Consultant to international organizations, government agencies, and financial institutions; Advisor, Public Investments Evaluation, Italy’s Presidency of Council of Ministers; Chairman, Banca Agricala Commerciale, San Marino. He was: Executive director, The World Bank Group; Member, executive board, IMF and Asian Development Bank; Head, Public Investments Evaluation, Italy’s Presidency of Council of Ministries; President, Central Bank, San Marino and San Marino Banking Association. General Accountant and Director Budget and Finance, Government of Sicily; Head, International Payments and Deputy head, International Financial Markets, Bank of Italy; Expert, High-Level Commission on World Bank Reform; Professor, Universities of Palermo and Salento. (Co-)author of studies and publications on economics and finance.