Relative Risk Aversion and the Transmission of Financial Crises

Abstract

We study how investor behaviour affects the transmission of financial crises. If investors exhibit decreasing relative risk aversion, then negative wealth shocks increase the risk premium required to hold risky assets. We integrate this into a second generation model of currency crises which allows for a competitiveness effect and for contagion through changes in fundamentals. The investor behaviour can lead to the transmission of financial crises even in the absence of the competitiveness effect, and makes multiple equilibria more likely. The possible stabilization effects of capital controls and a Tobin tax on the international transmission of financial crises are also studied.

Keywords: Financial crises, contagion, wealth effects, international asset pricing, relative risk aversion, capital controls, Tobin tax

JEL Classification: D91, F31, F32, G11, G15