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State of confidence, overborrowing and the macroeconomic stabilization puzzle

Eleonora Cavallaro () and Bernardo Maggi

No 2014/2, DSS Empirical Economics and Econometrics Working Papers Series from Centre for Empirical Economics and Econometrics, Department of Statistics, "Sapienza" University of Rome

Abstract: In this paper we model macroeconomic instability as the outcome of the dynamical interaction between debt accumulation and the “state of confidence” in a small open economy with a super-fixed exchange rate arrangement. Our analysis is set in a theoretical framework where balance-sheets effects govern external financing to firms and the state of confidence is largely pro-cyclical. We analyse the conditions for the dominance of unstable chains in the out-of-equilibrium dynamics which determine financial fragility, systemic instability and, as a consequence, macroeconomic stabilization puzzle. Indeed, the choice of a tight fiscal policy is likely to be destabilizing inasmuch as it exacerbates the liquidity crunch taking place in the course of a recession. At the same time, a reduction in interest rates may not be sufficient to switch off macroeconomic instability, and a direct stimulus to aggregate expenditure may be required to avoid an economic collapse. We conduct an “experimental” study with reference to Argentina during the currency board years in order to understand what the implications would have been for dynamical stability of “appropriate” monetary and fiscal policies oriented to macroeconomic stabilization. Our empirical results are based on the sensitivity analysis of a continuous-time econometric model and confirm the dangerousness of conventional austerity policies in times of recession.

Keywords: Continuous Time Econometrics; Debt; Macroeconomic stability. (search for similar items in EconPapers)
JEL-codes: C33 C62 C61 O11 O33 O34 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-mac
Date: 2014-01
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