Shock Propagation and Macroeconomic Fluctuations

TL;DR

This paper models how firm-level shocks propagate through production networks, generating macroeconomic fluctuations and tail risks, with the dynamics governed by the network's spectral properties and the rate of adjustment.

Contribution

It introduces a dynamic framework capturing shock propagation with overlapping adjustments, highlighting the role of spectral properties in macro fluctuations.

Findings

Interference of shocks explains macroeconomic volatility.

Degree distribution is less influential under dynamic adjustment.

Granular shocks account for a small part of observed volatility.

Abstract

We study how idiosyncratic firm-level shocks generate aggregate volatility and tail risk when they propagate through a production network under overlapping adjustment: new productivity draws arrive before the economy reaches the static equilibrium associated with earlier draws. Each innovation generates a `productivity wave' that mixes and dissipates over time as it travels through the production network. Macroeconomic fluctuations emerge from the interference between these waves of different vintages. The interference between these waves is governed by the dominant transient eigenvalue of the production network, and therefore so is the macroeconomic fluctuations they generate. In such a dynamic regime, the tail of the degree distribution is a markedly weaker determinant of macro fluctuations than in the fully adjusted static benchmark. And the macroeconomic significance of the degree-heterogeneity of production networks cannot be known without knowing the rate at which the economy converges to equilibrium or equivalently the spectral properties of the production network. More concretely, once we permit the time-averaging of shocks, granular shocks may account for only a small fraction of the empirically observed aggregate volatility.