State of confidence, overborrowing and the macroeconomic stabilization puzzle: a system dynamic approach

Eleonora Cavallaro () and Bernardo Maggi

No 174, Working Papers in Public Economics from Department of Economics and Law, Sapienza University of Roma

Abstract: We model macroeconomic instability as the outcome of the dynamic interaction between debt accumulation and the "state of confidence" in a small open economy with a super-fixed exchange-rate arrangement. We use a system dynamic approach and show that instability is a likely feature when macroeconomic behaviour is characterized by out-of-equilibrium dynamics with balance-sheet effects and deviation amplifying expectation formation rules that interact endogenously. We address the issue of the macroeconomic stabilization puzzle and carry out a quantitative evaluation based on sensitivity analysis with reference to Argentina, during the currency-board arrangement. We find that a tight fiscal policy is likely to be destabilizing inasmuch as it adds to the fall in expenditure, output and the "state of confidence". On the other side, a traditional monetary policy can fail in switching off macroeconomic instability if the reduction in interest rates does not compensate for the fall in the "state of confidence", whilst a direct stimulus to aggregate expenditure is required to avoid an economic collapse.

Keywords: macrodynamic financial fragility; (in-)stability; stabilization policies; sensitivity and continuous-time quantitative analysis (search for similar items in EconPapers)
JEL-codes: C61 E63 F31 F34 (search for similar items in EconPapers)
Pages: 35
Date: 2016-07
New Economics Papers: this item is included in nep-mac and nep-sog
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Citations: View citations in EconPapers (2)

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