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This study revisits and tests empirically the Portfolio Theory of Inflation (PTI), which analyzes how the effectiveness of macroeconomic policy in open and globally financially integrated economies is influenced by global investor decisions (Bossone, The portfolio theory of inflation and policy (in)effectiveness, 2019). The PTI shows that when an economy is heavily indebted and is perceived by the market to be poorly credible, investors hold it to a tighter intertemporal budget constraint and policies aimed to stimulate output growth dissipate into domestic currency depreciation and higher inflation, with limited or no impact on output, or with lower output and lower inflation. On the other hand, markets afford highly credible economies much greater space for effective and noninflationary macro policies. The study leads to a very basic advice: policymakers of an internationally highly integrated economy should keep public liabilities (the stock of both central bank money and public debt) at low levels: the larger the liabilities, the higher the degree of surrender of the country's national policy sovereignty to external forces and interests.

The Portfolio Theory of Inflation (PIT) proposed in this study investigates the role of global financial markets in determining the effectiveness of macroeconomic policy in open and fully financial integrated economies. The PIT adopts a modified version of the portfolio balance approach to exchange rate determination and incorporates intertemporal optimal choices from global investors. These investors allocate resources across national economies based on local investment opportunities and policy credibility: when a country's credibility is low, they hold its economy to a tighter intertemporal budget constraint and the issuance of what they deem as "excess" public sector liabilities causes the country's currency to depreciate and inflation to rise due to a large exchange rate pass-through, with limited or no impact on output. On the other hand, high credibility creates space for effective and noninflationary macro policies but, if such space is abused, credibility gets dissipated and higher inflation reflects such dissipation.

An international cooperative effort has been focused on the need to reduce financial fragility and systemic risks in global financial markets. Work is proceeding in three different areas: enhancing financial market transparency, improving the international financial architecture, and strengthening financial systems. Strengthening financial systems (the focus of this paper) means cooperating to promote principles and sound practices for financial stability through development of well-functioning financial systems and market discipline. Financial sector reform and development is much more than setting rules, articulating standards, approving legislation, and creating new institutions. All are important but ultimately behavior must be changed if there is to be meaningful and lasting financial reform. For that reason, this paper emphasizes the role of incentives to induce appropriate behavior. Developing countries have made important progress toward improved financial supervision in the past few years. Reforming financial sectors is a lengthy and complex process of institution building and incentive reorientation, whose success requires full ownership of, and participation in, the process by society and its government.