Keynesian Policy Space in "Globalized" Economies

By Biagio Bossone

PKES Working Paper 2405

April 2024

This article shows that in highly internationally financially integrated ("globalized") economies, policymakers' ability to implement effective expansionary macroeconomic policies, referred to in the article as "Keynesian policy space," is influenced by the portfolio decisions of a specific group of investors known as "Global investors." This conclusion arises from a two-country, open-economy model in which Global investors allocate capital internationally based primarily on their perception of the policy credibility of the countries where they invest their managed wealth. In countries that Global investors deem highly credible, expansionary macroeconomic policies prove effective in terms of stimulating output and resource employment. Conversely, in countries perceived as having weak credibility, the portfolio decisions of these investors may undermine the effectiveness of such policies. Consequently, the anticipated real effects of these policies may dissipate into domestic currency depreciation and higher inflation. Following the derivation and evaluation of this conclusion, the article explores various options for countries to establish and maintain Keynesian policy space.

Keywords: credibility; exchange rate; financial integration; global investor; inflation; intertemporal budget constraint; macro-policies

JEL classification: E31 E40 E50 E62 F31 G15 H30