Contagion and Volatility with Imperfect Credit Markets

31 Pages Posted: 1 Aug 2000 Last revised: 6 Oct 2010

See all articles by Pierre-Richard Agenor

Pierre-Richard Agenor

University of Manchester - School of Social Sciences

Joshua Aizenman

National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: July 1997

Abstract

This paper interprets contagion effects as a perceived increase (triggered by events occurring elsewhere) in the volatility of aggregate shocks impinging on the domestic economy. The implications of this approach are analyzed in a model with two types of credit market imperfections: domestic banks borrow at a premium on world capital markets, and domestic producers (whose demand for credit results from working capital needs) borrow at a premium from domestic banks which possess comparative advantage in monitoring the behavior of domestic agents. Financial intermediation spreads are shown to be determined by a markup that compensates for the expected cost of contract enforcement and state verification and for the expected revenue lost in adverse states of nature. Higher volatility of producers' productivity shocks increases both financial spreads and the producers' cost of capital, resulting in lower employment and higher incidence of default. The welfare effects of volatility are non-linear. Higher volatility does not impose any welfare cost for countries characterized by relatively low volatility and efficient financial intermediation. The adverse welfare effects are large (small) for countries that are at the threshold of full integration with international capital markets (close to financial autarky), that is, countries characterized by a relatively low (high) probability of default.

Suggested Citation

Agenor, Pierre-Richard and Aizenman, Joshua, Contagion and Volatility with Imperfect Credit Markets (July 1997). NBER Working Paper No. w6080. Available at SSRN: https://ssrn.com/abstract=226487

Pierre-Richard Agenor (Contact Author)

University of Manchester - School of Social Sciences ( email )

Oxford Road
Manchester, M13 9PL
United Kingdom

Joshua Aizenman

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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