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

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  • Eleonora Cavallaro
  • Bernardo Maggi

Abstract

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.

Suggested Citation

  • Eleonora Cavallaro & Bernardo Maggi, 2016. "State of confidence, overborrowing and the macroeconomic stabilization puzzle: a system dynamic approach," Working Papers 174, University of Rome La Sapienza, Department of Public Economics.
  • Handle: RePEc:sap:wpaper:wp174
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    References listed on IDEAS

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    Cited by:

    1. Cavallaro, Eleonora & Cutrini, Eleonora, 2019. "Distance and beyond: What drives financial flows to emerging economies?," Economic Modelling, Elsevier, vol. 81(C), pages 533-550.

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    More about this item

    Keywords

    macrodynamic financial fragility; (in-)stability; stabilization policies; sensitivity and continuous-time quantitative analysis;
    All these keywords.

    JEL classification:

    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy
    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis

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