State of confidence, overborrowing and the macroeconomic stabilization puzzle: a system dynamic approach
Eleonora Cavallaro () and
No 174, Working Papers from University of Rome La Sapienza, Department of Public Economics
We model macroeconomic instability as the outcome of the dynamic interaction between debt accumulation and the â€œstate of confidenceâ€ 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 â€œstate of confidenceâ€ . 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 â€œstate of confidenceâ€ , 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: F34 F31 E63 C61 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-mac and nep-sog
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