The Role of Psychic Distance in Contagion: A Gravity Model for Contagious Financial Crises

We synthesize the financial crisis contagion literature through the gravity model from physics and test the hypothesis that the severity of contagion relates positively to trade and financial linkages but negatively to psychic distance between countries, when macroeconomic fundamentals and institutional factors are controlled. The psychic distance variable, a behavioral predictor constructed along four dimensions including geographic distance, common language, development level and common membership, is of key interest in this study. Using data of financial crises originated in Mexico, Asia, Russia, and Brazil in the 1990s, we find empirical support for the hypothesis, particularly for the importance of psychic distance in analyzing financial crisis contagion.