Determining the Precise Dynamics of Contagion

One of the most peculiar economic phenomena currently known is contagion. Contagion, in its most basic form, is when either a market or a commodity faces economic woes as a result of another market or commodity, when in theory (or empirically) the two goods or markets aren’t linked. The most common method for identifying contagion empirically is by a sudden and significant increase in correlation between markets or commodities when one of the commodities or markets is in crisis. So far, literature on the subject has focused on proving the existence of contagion. Yet the relationship between a contagious good or market and the impacted goods or markets is often the result of a chain of events spurred by the failure of the contagious entity. Each of these events can, in theory, be explained using economic theory. This paper will focus on proving this hypothesis in the case of two types of contagion, during the subprime mortgage crisis of 2007 and the market crash of 1973-1974. During the mortgage crisis of 2007, the labor market experienced sharp increases in correlation with the mortgage bond market because capital markets depended on the health of the mortgage bond market. This form of contagion will be called “capital contagion”. During the market crash of 1973-1974, there was a considerable decrease in the production of energy from renewable energy sources triggered by skyrocketing oil prices, because oil’s nearly universal use in manufacturing meant the general price level in the US economy depended on oil prices. This form of contagion will be called “price level contagion”