Learning in International Markets and a Rational Expectation Approach to the Contagion Puzzle

I develop a general equilibrium model in which agents from two countries do not observe directly the long-run growth prospects of their economies. Instead, the agents rationally learn the hidden components through the Kalman filter applied to international consumption data. Learning endogenously produces: (i) a rational explanation of international contagion phenomenon, defined as changes in one country's asset prices in response to foreign news, that occurs in the absence of domestic news, (ii) large and time-varying international equity risk premia, and (iii) a resolution of the forward premium anomaly,defined as the tendency of high interest rate currencies to appreciate. Model-simulated moments match previous empirical findings of key movements studied in the international finance literature. Furthermore, by applying the theory to actual data during the Asian Financial Crisis, the simulated Hong Kong stock market index can quantitatively and qualitatively match data, including a sharp downturn that can be attributed to contagion from Thailand due to the learning mechanism