State of confidence, overborrowing and the macroeconomic stabilization puzzle: a system dynamic approach

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.