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How can macroeconomic policies reduce contagion risk?

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Contagion risk is the possibility that a financial shock in one country or region spreads to other countries or regions, causing a global crisis. Contagion risk can have severe consequences for the stability of the financial system, the growth of the economy, and the welfare of the people. How can macroeconomic policies reduce contagion risk? In this article, we will explore some of the main channels of contagion and some of the policy tools that can help mitigate them.

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Atiq-ur- Rehman

Associate Professor at Kashmir Institute of Economics, University of Azad Jammu and Kashmir

1 Fiscal policy

Fiscal policy refers to the government's decisions on spending and taxation. Fiscal policy can reduce contagion risk by providing stimulus to the economy, supporting vulnerable sectors and households, and maintaining fiscal sustainability. Stimulus can help boost demand, output, and employment, and reduce the risk of deflation and debt defaults. Supporting vulnerable sectors and households can help prevent widespread bankruptcies, unemployment, and poverty, and preserve social cohesion and trust. Maintaining fiscal sustainability can help avoid sovereign debt crises, preserve market access, and enhance credibility.

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Atiq-ur- Rehman

Associate Professor at Kashmir Institute of Economics, University of Azad Jammu and Kashmir
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Macroeconomic policies often encompass both fiscal and monetary policies, along with other broader economic approaches. Handling the Global Financial Crisis and mitigation of the impacts of COVID-19 are instances where such policies reduced the risk of contagion. In the face of these crises, majority of nations employed expansionary strategies. Notably, in Q2-2020, the UK's economy witnessed a reduction of 20%. This drastic downturn in a world's leading economy had the potential to trigger a widespread financial collapse. However, the UK countered this predicament by implementing simultaneous expansionary fiscal and monetary policies, which facilitated a recovery within just a few quarters.

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2 Monetary policy

Monetary policy refers to the central bank's actions to influence the money supply, interest rates, and exchange rates. Monetary policy can reduce contagion risk by providing liquidity to the financial system, easing financial conditions, and managing capital flows. Liquidity can help prevent bank runs, fire sales, and credit crunches, and ensure the smooth functioning of the payment system. Easing financial conditions can help lower borrowing costs, stimulate investment and consumption, and support asset prices. Managing capital flows can help avoid sudden stops, reversals, and currency crises, and maintain external balance.

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3 Macroprudential policy

Macroprudential policy refers to the regulation and supervision of the financial system to prevent systemic risk. Macroprudential policy can reduce contagion risk by enhancing the resilience of financial institutions, limiting the build-up of leverage and imbalances, and addressing cross-border spillovers. Resilience can help absorb losses, maintain solvency, and reduce the need for bailouts. Limiting leverage and imbalances can help avoid asset bubbles, credit booms, and financial fragility. Addressing cross-border spillovers can help coordinate policy actions, harmonize standards, and share information.

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4 Exchange rate policy

Exchange rate policy refers to the choice of the exchange rate regime and the degree of intervention in the foreign exchange market. Exchange rate policy can reduce contagion risk by providing flexibility, stability, or a combination of both. Flexibility can help adjust to external shocks, maintain competitiveness, and avoid currency mismatches. Stability can help anchor inflation expectations, reduce volatility, and attract foreign investment. A combination of both can help balance the trade-offs between flexibility and stability, depending on the circumstances and objectives.

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5 International cooperation

International cooperation refers to the coordination and collaboration of policies and institutions at the global or regional level. International cooperation can reduce contagion risk by providing financial assistance, policy advice, and surveillance. Financial assistance can help overcome liquidity shortages, restore confidence, and facilitate adjustment. Policy advice can help design and implement effective and consistent policies. Surveillance can help monitor and assess risks, vulnerabilities, and spillovers.

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6 Policy mix

Policy mix refers to the combination and consistency of different macroeconomic policies. Policy mix can reduce contagion risk by enhancing the effectiveness, efficiency, and credibility of policies. Effectiveness can help achieve the desired outcomes, such as stabilizing the economy, restoring growth, and preventing crises. Efficiency can help minimize the costs and trade-offs of policies, such as fiscal deficits, inflation, or distortions. Credibility can help anchor expectations, reduce uncertainty, and improve communication.

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7 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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How can macroeconomic policies reduce contagion risk?

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1 Fiscal policy

2 Monetary policy

3 Macroprudential policy

4 Exchange rate policy

5 International cooperation

6 Policy mix

7 Here’s what else to consider

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