Sector-Specific Substitution and the Effect of Sectoral Shocks

TL;DR

This paper provides new sector-specific estimates of input substitution elasticity, showing that sectoral differences significantly influence how shocks propagate through prices and GDP, challenging previous uniform elasticity assumptions.

Contribution

It introduces a novel empirical method to estimate sector-specific substitution elasticities using BEA data, revealing meaningful differences across sectors and their impact on economic responses.

Findings

Sector-specific elasticities vary significantly across industries.

Uniform elasticity estimates are biased downward compared to sector-specific estimates.

Sector-specific substitution elasticity affects the magnitude of price and GDP responses to shocks.

Abstract

How a shock to an individual sector propagates to the prices of other sectors and aggregates to GDP depends on how easily sectoral goods can be substituted in production, which is determined by the intermediate input substitution elasticity. Past estimates of this parameter in the US have been restrictive: they have assumed a common elasticity across industries, and have ignored the use of imports in production. This paper uses a novel empirical strategy to produce new estimates without these restrictions, by exploiting variation in import ratios and input expenditure shares from the BEA Input-Output Accounts. I find that sectors differ meaningfully in their ability to substitute inputs in production, and that the uniform estimate of the intermediate input substitution elasticity is biased downwards relative to the median sector-specific estimate. Relative to imposing the uniform elasticity, sector-specific substitution causes domestic prices to rise more in response to oil import shocks and less in response to semiconductor import shocks. It also implies the average GDP response to a sectoral business cycle is 0.35% higher, making sectoral business cycles 17.7% less costly.