Econometric Issues in the Analysis of Contagion
Erasmus University Rotterdam (EUR) - Department of Econometrics; De Nederlandsche Bank
M. Hashem Pesaran
University of Southern California; Cambridge University - Faculty of Economics; CESifo (Center for Economic Studies and Ifo Institute for Economic Research); Institute for the Study of Labor (IZA)
CESifo Working Paper Series No. 1176
This paper presents a canonical, econometric model of contagion and investigates the conditions under which contagion can be distinguished from inter-dependence. In a two-country (market) setup it is shown that for a range of fundamentals the solution is not unique, and for sufficiently large values of the contagion coefficients it has interesting bifurcation properties with bimodal density functions. The extension of the model to herding behaviour is also briefly discussed. To identify contagion effects in the presence of inter-dependencies the equations for the individual markets or countries must contain country (market) specific forcing variables. This sheds doubt on the general validity of the correlation-based tests of contagions recently proposed in the literature which do not involve any country (market) specific fundamentals. Finally, we show that ignoring inter-dependence can introduce an upward bias in the estimate of the contagion coefficient, and using Monte Carlo experiments we further show that this bias could be substantial.
Number of Pages in PDF File: 50
Keywords: Contagion, Inter-dependence, Identification, Financial Crises
JEL Classification: C10, C123, G10, G15working papers series
Date posted: January 2, 2004
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