Financial Contagion

Posted: 4 Jan 2000

See all articles by Franklin Allen

Franklin Allen

Imperial College London

Douglas M. Gale

New York University (NYU) - Department of Economics

Abstract

Financial contagion is modeled as an equilibrium phenomenon. Because liquidity preference shocks are imperfectly correlated across regions, banks hold interregional claims on other banks to provide insurance against liquidity preference shocks. When there is no aggregate uncertainty, the first-best allocation of risk sharing can be achieved. However, this arrangement is financially fragile. A small liquidity preference shock in one region can spread by contagion throughout the economy. The possibility of contagion depends strongly on the completeness of the structure of interregional claims. Complete claims structures are shown to be more robust than incomplete structures.

JEL Classification: F36, G12

Suggested Citation

Allen, Franklin and Gale, Douglas M., Financial Contagion. Journal of Political Economy, Vol. 108, No. 1, February 2000. Available at SSRN: https://ssrn.com/abstract=202376

Franklin Allen (Contact Author)

Imperial College London ( email )

South Kensington Campus
Exhibition Road
London, Greater London SW7 2AZ
United Kingdom

Douglas M. Gale

New York University (NYU) - Department of Economics ( email )

269 Mercer Street, 7th Floor
New York, NY 10011
United States
(212) 998-8944 (Phone)
(212) 995-3932 (Fax)

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