Confidence spillovers, financial contagion, and stagnation

Konstantin Platonov

Journal of International Money and Finance, 2024, vol. 148, issue C

Abstract: Financial crises tend to spread across countries, causing equity price crashes that cannot be fully explained by fundamentals. This paper introduces a two-country dynamic general equilibrium model of global financial crises that distinguishes between interdependence and financial contagion. Interdependence arises through trade and capital flows, while contagion occurs through a new channel: confidence spillovers. In the model, contagion is possible due to multiple dynamic and steady-state equilibria, even with fully rational consumers. Self-fulfilling beliefs about equity prices can shift the economy between equilibria, amplifying negative effects and causing contagion. The model has three policy implications. Firstly, monetary policy can offset recessions without causing inflation. Coordinated international policy can potentially improve welfare further. Secondly, capital controls can prevent contagion. Lastly, increased trust in government can mitigate negative confidence shocks. These recommendations emphasize the role of beliefs, where pessimism can spread internationally via the confidence channel, leading to contagion.

Keywords: Financial crisis; Contagion; Stagnation; Confidence; Beliefs; Asset prices; Indeterminacy; Multiple equilibria; Endogenous business cycle (search for similar items in EconPapers)
JEL-codes: E32 E50 F41 F44 (search for similar items in EconPapers)
Date: 2024
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:jimfin:v:148:y:2024:i:c:s0261560624001505

DOI: 10.1016/j.jimonfin.2024.103163

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