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The macrodynamics of financial fragility within a hard peg arrangement

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  • Cavallaro, Eleonora
  • Maggi, Bernardo
  • Mulino, Marcella

Abstract

The paper presents an open-economy macrodynamical growth model with the aim of giving an endogenous characterisation to the process that leads a small country with a currency-board arrangement to accumulate dangerously high levels of external debt and become vulnerable to macroeconomic instability. The macrodynamics of the model results from the combination of the commitment to maintain the peg - that makes liquidity closely dependent on the dynamics of foreign reserves - and the non-linear real and financial interactions that drives the pro-cyclical behaviour of the economy. Within this context, the external financing ease during an economic upswing leads to debt-supported growth and financial fragility; the consequent deterioration of profitability expectations brings about a capital reversal that, in the absence of monetary stabilisation tools, makes the currency arrangement unsustainable. A financial crisis may thus turn into a currency crisis. We run a continuous-time estimation of a non-linear differential equations system for Argentina during the years of the currency-board arrangement. We find that two steady-state solutions exist. The local stability and sensitivity analysis show that both equilibria are unstable and that the qualitative nature of the equilibria depends in particular on lenders' responsiveness to the degree of leverage. We also show that relaxing the assumption on the currency arrangement and allowing for an autonomous monetary policy makes both equilibria stable.

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Bibliographic Info

Article provided by Elsevier in its journal Economic Modelling.

Volume (Year): 28 (2011)
Issue (Month): 5 (September)
Pages: 2164-2173

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Handle: RePEc:eee:ecmode:v:28:y:2011:i:5:p:2164-2173

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Web page: http://www.elsevier.com/locate/inca/30411

Related research

Keywords: Currency board Financial crisis Monetary policy Continuous time econometrics Stability Sensitivity;

References

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Cited by:
  1. Eleonora Cavallaro & Bernardo Maggi, 2014. "State of confidence, overborrowing and the macroeconomic stabilization puzzle," DSS Empirical Economics and Econometrics Working Papers Series 2014/2, Centre for Empirical Economics and Econometrics, Department of Statistics, "Sapienza" University of Rome.

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