Nber Working Paper Series Nominal Stability and Financial Globalization

Over the one and a half decades prior to the global financial crisis, advanced economies experienced a large growth in gross external portfolio positions. This phenomenon has been described as Financial Globalization. Over roughly the same time frame, most of these countries also saw a substantial fall in the level and variability of inflation. Many economists have conjectured that financial globalization contributed to the improved performance in the level and predictability of inflation. In this paper, we explore the causal link running in the opposite direction. We show that a monetary policy rule which reduces inflation variability leads to an increase in the size of gross external positions, both in equity and bond portfolios. This is a highly robust prediction of open economy macro models with endogenous portfolio choice. It holds across many different modeling specifications and parameterizations. We also present preliminary empirical evidence which shows a negative relationship between inflation volatility and the size of gross external positions. Michael B. Devereux Department of Economics University of British Columbia 997-1873 East Mall Vancouver, BC V6T 1Z1 CANADA and NBER [email protected] Ozge Senay Department of Economics University of St. Andrews St. Andrews, Fife KY16 9AL UK [email protected] Alan Sutherland Department of Economics University of St. Andrews St. Andrews, Fife KY16 9AL UK [email protected]