State of confidence, overborrowing and macroeconomic stabilization in out-of-equilibrium dynamics

Eleonora Cavallaro () and Bernardo Maggi

Economic Modelling, 2016, vol. 59, issue C, 210-223

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)
Date: 2016
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:ecmode:v:59:y:2016:i:c:p:210-223

DOI: 10.1016/j.econmod.2016.06.015

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