Production Network Dynamics and the Propagation of Shocks

Abstract

This paper uses a firm-to-firm transaction dataset to evaluate quantitatively how shocks propagate through production networks when their underlying links are costly to form and adjust. I document a set of facts consistent with adjustment frictions in these relationships. In particular, these links react sluggishly to firm-specific international trade shocks and are unresponsive to small shocks but strongly responsive to large shocks. Guided by these facts, I develop a dynamic general equilibrium model with endogenous production networks where links have adjustment frictions. Solving for the links’ dynamics with a large number of firms is made possible by leveraging the empirical sparsity of firm-to-firm links. To measure the aggregate relevance of these adjustment frictions, I estimate the model using a simulated method of moments and evaluate how international trade shocks during the Great Recession propagated in Chile. Without links’ adjustment frictions, and thus with a totally flexible network, the output losses from these shocks would have been 30 percent lower. The application highlights the relevance that dynamics in firm-to-firm links has not only for firms’ connectivity but also for how aggregate output responds to shocks.

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