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State of confidence, overborrowing and the macroeconomic stabilization puzzle

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  • Eleonora Cavallaro

    ()
    (Sapienza Universita' di Roma)

  • Bernardo Maggi

    ()
    (Sapienza Universita' di Roma)

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.

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File URL: http://www.dss.uniroma1.it/RePec/sas/wpaper/20142_mc.pdf
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Bibliographic Info

Paper provided by Centre for Empirical Economics and Econometrics, Department of Statistics, "Sapienza" University of Rome in its series DSS Empirical Economics and Econometrics Working Papers Series with number 2014/2.

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Length: 25 pages
Date of creation: Jan 2014
Date of revision:
Handle: RePEc:sas:wpaper:20142

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Keywords: Continuous Time Econometrics; Debt; Macroeconomic stability.;

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  1. David Goldreich & Bernd Hanke & Purnendu Nath, 2005. "The Price of Future Liquidity: Time-Varying Liquidity in the U.S. Treasury Market," Review of Finance, Springer, vol. 9(1), pages 1-32, 03.
  2. Simona Delle Chiaie & Bernardo Maggi, 2014. "Italian Government debt liquidity, is it of value?," DSS Empirical Economics and Econometrics Working Papers Series 2014/3, Centre for Empirical Economics and Econometrics, Department of Statistics, "Sapienza" University of Rome.
  3. Maggi Bernardo & Cavallaro Eleonora & Mulino Marcella, 2012. "The Macrodynamics of External Overborrowing and Systemic Instability in a Small Open Economy," Studies in Nonlinear Dynamics & Econometrics, De Gruyter, vol. 16(2), pages 1-27, April.
  4. Asada, Toichiro & Chiarella, Carl & Flaschel, Peter & Mouakil, Tarik & Proaño, Christian R., 2010. "Stabilizing an unstable economy: On the choice of proper policy measures," Economics - The Open-Access, Open-Assessment E-Journal, Kiel Institute for the World Economy, vol. 4(21), pages 1-43.
  5. Cavallaro, Eleonora & Maggi, Bernardo & Mulino, Marcella, 2011. "The macrodynamics of financial fragility within a hard peg arrangement," Economic Modelling, Elsevier, vol. 28(5), pages 2164-2173, September.
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