Stability and Social Welfare in International Lending Networks

This paper examines the behavior of international lending networks a currency crisis, specifically focusing on connectivity as a differentiating factor between financial networks. The model consists of economies that borrow and lend capital in nominal units of the creditor's currency. A shock then leads to the depreciation of the currency of a single economy which causes exchange rate fluctuations throughout the financial network. This alters the nominal value of debts that economies are required to repay, potentially putting them at risk of default. The results show that the architecture of a financial network is an important factor in minimizing the number of defaults and maximizing total social welfare. An increase in connectivity among economies leads to both greater stability and greater total social welfare of a network, since diversification of liabilities decreases fluctuations in exchange rates.