CONTAGION AND VOLATILITY WITH IMPERFECT CREDIT MARKETS

This paper interprets contagion effects as an increase in the volatili ty of shocks impinging on the economy. The implications of this approa ch are analyzed in a model in which domestic banks borrow at a premium on world capital markets, and domestic producers borrow at a premium from domestic banks. Financial spreads depend on a markup that compens ates lenders, in particular; for the expected cost of contract enforce ment. Higher volatility increases financial spreads and the producers' cost of capital resulting in lower employment and higher incidence of default. Welfare effects are nonlinearly related to the degree of int ernational financial integration.