Third-person Effect and Financial Contagion in the Context of a Global Game

In this paper we present a psychological channel of financial contagion. We incorporate this new channel of financial contagion in the global game. Our basic assumption is that agents are overestimating the influence of negative messages they ascribe to others, and are thus acting on the basis of this perception. We resort to the psychological studies on the so-called third-person effect to justify this assumption. We show that the third-person effect is rationalizable. Our model has the feature that a crisis in a foreign country can be transmitted to the domestic country, even though there has been no changes in domestic fundamentals. Our model also provides intuitive explanations to the empirical observations that many governments have lost in a confidence game in the past crisis episodes.