International Financial Contagion and the IMF: A Theoretical Framework

Peter Clark and Haizhou Huang

No 2001/137, IMF Working Papers from International Monetary Fund

Abstract: We provide a model of contagion where countries borrow or lend for consumption smoothing at the market interest rate or a lower IMF rate. Highly indebted countries hit by large negative shocks to output will default. The resulting reduction in loanable funds raises interest rates, increases the vulnerability of other indebted countries, and can generate further rounds of defaults. In this environment the IMF can limit default and internalize the externality generated by contagion through its lending with conditionality. We characterize the IMF's optimal lending decision in mitigating the loss in world consumption.

Keywords: WP; international financial contagion; conditionality; IMF; equilibrium interest rate; world interest rate; IMF charge; loanable funds; interest rate increase; loan volume; fund conditionality; IMF subsidy; world capital market; Consumption; International capital markets; Loans; Financial contagion; Moral hazard (search for similar items in EconPapers)
Pages: 31
Date: 2001-09-01
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Citations: View citations in EconPapers (5)

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