The Macrodynamics of External Overborrowing and Systemic Instability in a Small Open Economy

Bernardo Maggi, Eleonora Cavallaro () and Marcella Mulino ()

Studies in Nonlinear Dynamics & Econometrics, 2012, vol. 16, issue 2, 27

Abstract: The paper presents a monetary growth model for a small emerging economy with a currency board arrangement. The integration into global financial markets determines an acceleration of debt-creating capital inflows that boosts growth and the prospect of future profits, and leads to the building-up of large imbalances in the public and private sectors. Financial fragility undermines the state of confidence and determines an endogenous capital reversal. At this stage, the strong commitment to maintain the peg leaves no room for stabilization purposes and leads to systemic instability. We run a continuous-time estimation of the non-linear differential equations system of the model, with reference to Argentina during the years of the currency-board arrangement. We find two steady-state solutions, corresponding to a high-interest rate and a low-interest rate equilibrium, respectively. The local stability and sensitivity analysis show that both equilibria are unstable and that the system is intrinsically fragile. We show that even a tighter fiscal policy, according to the prescriptions of international institutions, results ineffective in improving stability.

Date: 2012
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DOI: 10.1515/1558-3708.1932

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