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Financial Instability

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Financial Instability

The soaring volume of international finance and increased

interdependence in recent decades has increased concerns about volatility and

threats of a financial crisis. This has led many to investigate and analyze the

origins, transmission, effects and policies aimed to impede financial

instability. This paper argues that financial liberalization and speculation

are the most reflective explanations for instability in financial markets and

that financial instability is likely to be transmitted globally with far

reaching implications on real sector performance. I conclude the paper with the

argument that a global transaction tax would be the most effective policy to

curb financial instability and that other proposed policies, such as target

zones and the creation of a supranational institution, are either unfeasible or

unattainable.

INSTABILITY IN FINANCIAL MARKETS

In this section I examine four interpretations of how financial

instability arises. The first interpretation deals with speculation and the

subsequent “bandwagoning” in financial markets. The second is a political

interpretation dealing with the declining status of a hegemonic anchor of the

financial system. The question of whether regulation causes or mitigates

financial instability is raised by the third interpretation; while the fourth

view deals with the “trigger point” phenomena.

To fully comprehend these interpretations we must first understand and

differentiate between a “currency” and “contagion” crisis. A currency crisis

refers to a situation is which a loss of confidence in a country's currency

provokes capital flight. Conversely, a contagion crisis refers to a loss of

confidence in the assets denominated in a particular currency and the subsequent

global transmission of this shock.

One of the more paramount readings of financial instability pertains to

speculation. Speculation is exhibited in a situation where a government

monetary or fiscal policy (or action) leads investors to believe that the

currency of that particular nation will either appreciate or depreciate in terms

relative to those of other countries. Closely associated with these speculative

attacks is what is coined the “bandwagon” effect. Say for example, that a

country's central bank decides to undertake an expansionary monetary policy. A

ne...

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