A model of contagion without trading relations

The paper explains the origin of the financial crisis in one country and its spread to other countries—contagion, in a dynamic model of international capital inflow. The origin of the crisis is rooted in this model in the common international loan market, and crisis can occur even when the countries are not interconnected via bi-lateral or multi-lateral trade and commerce, when connected via trade or commerce the contagion hits with a stronger effect. The paper introduces country-level heterogeneity of risk of default for individual countries in the borrowing group which generates interesting cases of the contagion effect. A change in the risk of default of an individual country adversely affects the total supply in the international loan market leading to crises in other countries via increased international interest rates. It has an enhanced effect when the risk of default depends on the lagged domestic productivity of the borrowing country. The model can explain various episodes of financial crisis in a common framework and can be usefully employed for policy formulation.