What is a Financial Contagion?

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belarafon | High School Teacher | (Level 2) Educator Emeritus

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In the study of economics, a Financial Contagion is the spread of small financial shocks throughout an economic system. The system does not need to be directly connected, nor does it need to be in a state of specific growth or decline. The theory is that although a financial shock might be contained to one particular sector, the increasing connectedness of economic systems allows people to act on information quickly and definitively, thus allowing what might have been a minor shift to spread.

An example of this would be short-selling a stock. If a large holder dumps stock at a low price, other investors might follow suit, causing a rapid devaluation of the stock and company holdings. Although the other investors didn't have the same information as the original seller, they watched the sale and decided that there was something to be gained by selling low.

Another example is currency value. Because of the immense amount of money that is traded over national lines via the Internet and World Stock Market, a shift one way or another can have widespread effect on other prices, even if they are not directly connected to the currency in question. The 1997 Asian Financial Crisis is an example of a monetary financial contagion, where the devaluation of the Thai Baht caused many investors to pull out of other Asian currencies, devaluing stocks and causing inflation and increased private debt.


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