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Financial instability contagion: a dynamical systems approach

Giuseppe Castellacci and Youngna Choi

Quantitative Finance, 2014, vol. 14, issue 7, 1243-1255

Abstract: We build a multi-agent dynamical system for the global economy to investigate and analyse financial crises. The agents are large aggregates of a subeconomy, and the global economy is a collection of subeconomies. We use well-known theories of dynamical systems to represent a financial crisis as propagation of a negative shock on wealth due the breakage of a financial equilibrium. We first extend the framework of the market instability indicator , an early warning signal defined for a single economy as the spectral radius of the Jacobian matrix of the wealth dynamical system. Then, we formulate a quantitative definition of instability contagion in terms thereof. Finally, we analyse the mechanism of instability contagion for both single and multiple economies. Our contribution is to provide a methodology to quantify and monitor the level of instability in sectors and stages of a structured global economic model and how it may propagate through its components.

Date: 2014
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Handle: RePEc:taf:quantf:v:14:y:2014:i:7:p:1243-1255