Contagion

Key Highlights

• Contagion describes the swift transmission of financial or economic turmoil across markets, industries, or nations, potentially triggering widespread instability or crisis.

• Types of contagion includes spillover effects, pure financial contagion and systemic risk.

What is Contagion?

Contagion describes the swift transmission of financial or economic turmoil across markets, industries, or nations, potentially triggering widespread instability or crisis. Originally a medical term, it describes how shocks propagate through interconnected financial and economic systems.

Key Characteristics

• Nature of Spread: Financial disturbances, such as crises, asset price declines, or volatility, expand quickly across entities, markets, or regions.

• Triggers: Can stem from domestic or global events, including bank failures, sharp market drops, or macroeconomic shocks.

Mechanisms of Spread

• Financial Linkages: Direct connections, like cross-border lending or investments, enable rapid transmission of losses or panic.

• Investor Behavior: Herding, panic selling, or loss of confidence can amplify contagion, often regardless of economic fundamentals.

• Trade and Economic Ties: Disruptions spread through trade linkages, currency markets, or global supply chains.

• Information Gaps: Misinformation or uncertainty about a shock’s scope can trigger overreactions, worsening the spread.

Types of Contagion

• Spillover Effects: Fundamental-based contagion driven by real economic connections, such as trade or investment flows.

• Pure Financial Contagion: Crises spread without direct economic ties, fueled by market sentiment, fear, or investor mimicry.

• Systemic Risk: The failure of a major institution or market threatens the entire financial system, closely tied to contagion.