Habit formation and the transmission of financial crises

We study how external habit formation by investors affects the transmission of financial crises. Habit formation increases the effective risk premium on assets when there is a negative wealth shock and introduces non-linearities which can lead to multiple equilibria. We embed this investor’s behavior in the Jeanne (1997) model which allows for a competitiveness effect and for contagion through changes in fundamentals. Habit formation, however, can lead to transmission of financial crises even in the absence of the competitiveness effect, and makes multiple equilibria more likely. The possible stabilization effects of capital controls and a Tobin tax on the international transmission of financial crises are also discussed.