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This is usually a birth injury. When the head is delivered, traction must often be applied to the neck. If the large grouping of nerves that comes off the cervical spine and controls the arm and hand is over-stretched in the course of the delivery, swelling may develop around the nerve root and cause paralysis of those nerves by pressure effect (the same effect that happens when pressure on the nerves running through the elbow produces temporary paralysis of your arm when you sleep on it). The baby with an Erb's palsy holds his arm down at his side, rather than normally flexed up against the body. If the startle reflex is triggered, the affected arm does not move properly. Usually the paralysis is very temporary - at most a day or two. Infrequently, the paralysis represents actual tearing of the nerves and will last much longer. Physical therapy will be necessary to help the child recover, and surgery may even be needed in some cases. There is more detailed information on this topic at the United Brachial Plexus Network website.
Classic Erb's palsy is actually damage to the upper cervical nerve roots, C5-6. These are part of the brachial plexus (the fifth cervical root C5 through the first thoracic root T1), a web of nerves that exit from the spinal cord and supply innervation to the shoulder, arm, and hand. C5-6 injury chiefly produces problems with shoulder and elbow function. More severe injury may involve the next root down in the chain, C7, which causes hand and wrist weakness.