The Portfolio Theory of Inflation and Policy (in)Effectiveness: Exploring it Further and Righting the Wrongs

Abstract

Abstract This article revisits the Portfolio Theory of Inflation (PTI) proposed in my original work published earlier (Bossone, B. (2019, 4 June). The portfolio theory of inflation and policy (in)effectiveness. Economics Journal, 1–25. Article No. 2019-33.), with a view to further articulate its findings and implications. The article adds to the micro- and macro-foundations of the PTI model of the economy, framing the portfolio choices of global investors more rigorously, providing richer analysis of their macroeconomic effects, and in the process also correcting errors contained in the original PTI formulation. The article explores additional dimensions of how capital allocation choices by global investors interact with government macro-policies, and further studies how such choices shape the space available to country authorities for active macro-policies. The article further evaluates the results from the revisited model on the dynamics of exchange rate, inflation, and output following macro-policy shocks, and appraises the implications of the PTI for macro-policy effectiveness when due consideration is given to stock variables, as opposed to flow variables only, in the context of highly internationally financially integrated economies. Finally, the article considers what is new about the PTI as a theory of inflation and clarifies some of its possible misinterpretations.