International Financial Contagion in Currency Crisis
The authors in the Journal of International Money and Finance argue that market crises seem to spread from one country to another in a kind of "contagion" (Caramazza, et al., 2004). Why does this happen? They wonder first of all what makes one crisis "…spill over to others," and moreover, the factors that might account for the "…temporal clustering of crises" appear to break down into four areas of concern.
First, when a financial glitch occurs in one country -- like the increase in U.S. interest rates in the 1980s, which contributed to the 1994-95 Mexican peso crisis -- it is considered a "common shock" and deserves close observation; secondly, if a country depreciates its currency, that act can negatively impact its trading partners (Caramazza, 53). The third aspect references the fact that investors quickly rid themselves of their assets when a crisis occurs, contributing to the downslide in other countries, Caramazza continues (53); the fourth aspect relates to countries that have weakness in their financial systems can more quickly be sucked into the contagion.
On page 56 Caramazza backs up the assumptions made by pointing out that during the Mexican peso crisis, nine other countries had "substantial currency pressures" within six months of that Mexican crisis. As to how these countries fall prey to financial downslides, one important account Caramazza and colleagues embrace -- the benchmark model -- is among the more easily understood and logical explanations: to wit, if there was slow GDP growth in the three years previous to the crisis and if the exchange rate...
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