Contagion and Volatility with Imperfect Credit Markets
33 Pages Posted: 15 Feb 2006
Date Written: October 1997
This paper interprets contagion effects as an increase 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. Higher volatility of producers` productivity shocks increases both domestic and foreign financial spreads and the producers` cost of capital, resulting in lower employment and higher incidence of default. Welfare effects are nonlinearly related to the degree of international financial integration.
Keywords: Credit market imperfections, volatility, interest rate spreads
JEL Classification: E44, F32, F34
Suggested Citation: Suggested Citation