Financial Instability Contagion: A Dynamical Systems Approach
Posted: 5 Sep 2013
Date Written: August 31, 2013
We build an agent-based dynamical system for the global economy to investigate and analyze 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 analyze 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 between its components.
This paper can be regarded as a companion to to our "Sovereign Credit Risk Contagion: A Dynamical Systems Approach" available on this site. Here we more extensively lay out the theoretical underpinning of the multi-economy model and the definition of contagion.
Keywords: sovereign credit, systemic risk, contagion, multi-economy model, market instability indicator
JEL Classification: C6, C62, E3, E6, E32, E66, G1, G10, N1, N10
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