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Strong Contagion with Weak Spillovers

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  • Ellison, Martin
  • Graham, Liam
  • Vilmunen, Jouko

Abstract

In this Paper, we develop a model which explains why events in one market may trigger similar events in other markets, even though at first sight the markets appear to be only weakly related. We allow for multiple equilibria and learning dynamics in each market, and show that a jump between equilibria in one market is contagious because it more than doubles the probability of a similar jump in another market. We claim that contagion is strong since equilibrium jumps become highly synchronized across markets. Spillovers are weak because the instantaneous spillover of events from one market to another is small. To illustrate our result, we demonstrate how a currency crisis may be contagious with only weak links between countries. Other examples where weak spillovers would create strong contagion are various models of monetary policy, imperfect competition and endogenous growth.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 4762.

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Date of creation: Nov 2004
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Handle: RePEc:cpr:ceprdp:4762

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Keywords: contagion; escape dynamics; learning; spillovers;

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  1. Williams, Noah, 2004. "Small noise asymptotics for a stochastic growth model," Journal of Economic Theory, Elsevier, vol. 119(2), pages 271-298, December.
  2. Philippe AGHION & Philippe BACCHETTA & Abhijit BANERJEE, 1999. "A Simple Model of Monetary Policy and Currency Crises," Cahiers de Recherches Economiques du Département d'Econométrie et d'Economie politique (DEEP) 9914, Université de Lausanne, Faculté des HEC, DEEP.
  3. Cho, In-Koo & Kasa, Kenneth, 2008. "Learning Dynamics And Endogenous Currency Crises," Macroeconomic Dynamics, Cambridge University Press, vol. 12(02), pages 257-285, April.
  4. Masson, Paul, 1999. "Contagion:: macroeconomic models with multiple equilibria," Journal of International Money and Finance, Elsevier, vol. 18(4), pages 587-602, August.
  5. Thomas Sargent & Noah Williams & Tao Zha, 2006. "The Conquest of South American Inflation," NBER Working Papers 12606, National Bureau of Economic Research, Inc.
  6. William Poole, 2002. "Flation," Speech 49, Federal Reserve Bank of St. Louis.
  7. Kenneth Kasa, 2000. "Learning, large deviations, and recurrent currency crises," Working Paper Series 2000-10, Federal Reserve Bank of San Francisco.
  8. Gerali, Andrea & Lippi, Francesco, 2001. "On the 'Conquest' of Inflation," CEPR Discussion Papers 3101, C.E.P.R. Discussion Papers.
  9. Bullard, James & Cho, In-Koo, 2003. "Escapist policy rules," CFS Working Paper Series 2003/38, Center for Financial Studies (CFS).
  10. Bruce McGough, 2003. "Shocking Escapes," Computing in Economics and Finance 2003 294, Society for Computational Economics.
  11. Giorgio Primiceri, 2005. "Why Inflation Rose and Fell: Policymakers' Beliefs and US Postwar Stabilization Policy," NBER Working Papers 11147, National Bureau of Economic Research, Inc.
  12. Robert Tetlow & Peter von zur Muehlen, 2004. "Avoiding Nash Inflation: Bayesian and Robus Responses to Model Uncertainty," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 7(4), pages 869-899, October.
  13. In-Koo Cho & Noah Williams & Thomas J. Sargent, 2002. "Escaping Nash Inflation," Review of Economic Studies, Oxford University Press, vol. 69(1), pages 1-40.
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Cited by:
  1. Thomas Sargent & Noah Williams & Tao Zha, 2006. "The conquest of South American inflation," Working Paper 2006-20, Federal Reserve Bank of Atlanta.

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