Financial Instability

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Term Paper Title	Financial Instability
# of Words	3364
# of Pages (250 words per page double spaced)	13.46

Financial Instability

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
neoclassical interpretation tells us that this will lower the domestic interest
rates, thus lowering the rate of return ...

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