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Financial Crisis and Contagion: A Dynamical Systems Approach

Author

Listed:
  • Youngna Choi

    (Department of Mathematical Sciences - MSU - Montclair State University [USA])

  • Raphaël Douady

    (CES - Centre d'économie de la Sorbonne - UP1 - Université Paris 1 Panthéon-Sorbonne - CNRS - Centre National de la Recherche Scientifique)

Abstract

We use a multi-agent-based model to investigate and analyze financial crises where agents are large aggregates of the economic system under consideration. We analyze financial crises as the breakage of a dynamic financial equilibrium. We suggest that when the equilibrium is stable, a small perturbation is absorbed by the market. On the other hand, when the market becomes unstable, perturbations propagate and amplify through the system, and contagion and systemic risk occur, resulting in a global financial crisis. The market instability indicator is the spectral radius of the Jacobian matrix of a dynamical system driving the evolution of the economy. Entries of this Jacobian matrix can be computed by estimating the elasticities of flows of funds between aggregate agents. The higher the elasticities, the larger the entries of the Jacobian matrix and the more unstable the economy. High leverage and borrowing capacity constraints increase elasticities and make the market unstable as soon as the market instability indicator is above the critical value 1. In order to avoid deflation and economic collapse in 2008, the US government had a very strong reaction with Quantitative Easing and TARP. This put the market under rapid oscillations of very high amplitude and chaotic behavior, making long term forecasts inefficient. By correctly monitoring and utilizing elasticities, governments facing a major crisis may be able to optimize the efficiency of monetary and fiscal policies and accurately allocate their support to the various sectors of the economy, as opposed to being part of the origination of market chaos by inappropriate allocation of government resources.

Suggested Citation

  • Youngna Choi & Raphaël Douady, 2013. "Financial Crisis and Contagion: A Dynamical Systems Approach," Post-Print hal-00666752, HAL.
  • Handle: RePEc:hal:journl:hal-00666752
    DOI: 10.1017/CBO9781139151184.024
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    Cited by:

    1. Castellacci, Giuseppe & Choi, Youngna, 2015. "Modeling contagion in the Eurozone crisis via dynamical systems," Journal of Banking & Finance, Elsevier, vol. 50(C), pages 400-410.
    2. Youngna Choi, 2019. "Borrowing Capacity, Financial Instability, And Contagion," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 22(01), pages 1-25, February.
    3. Youngna Choi, 2018. "Masked Instability: Within-Sector Financial Risk in the Presence of Wealth Inequality," Risks, MDPI, vol. 6(3), pages 1-15, June.
    4. Francesca Biagini & Andrea Mazzon & Thilo Meyer-Brandis, 2016. "Liquidity induced asset bubbles via flows of ELMMs," Papers 1611.01440, arXiv.org, revised Nov 2016.
    5. Michael I.C. Nwogugu, 2019. "Complex Systems, Multi-Sided Incentives and Risk Perception in Companies," Palgrave Macmillan Books, Palgrave Macmillan, number 978-1-137-44704-3, March.

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