Propagation of crises across countries:Trade roots of contagion effects

The paper provides an explanation of the mechanisms underlying trade roots of the contagion
effects emanating from the recent turmoils. It is argued that under demand uncertainty risk averse
behavior of firms provides a basis for international trade. The paper shows by means of a simple
two-country model that risk averse firms operating in perfectly competitive markets with
uncertainty of demand tend to diversify markets what gives a basis for international trade in
identical commodities even between identical countries. It is shown that such trade may be welfare
improving despite efficiency losses due to cross-hauling and transportation costs. The analysis
reveals that change of the expectations concerning market conditions caused by the turmoil in the
neighbor country (i.e., shift in the perception of market conditions) may lead to macroeconomic
destabilization (increase in price level and unemployment, worsening of terms of trade, and
deterioration of trade balance).