Propagation of Financial Shocks in an Input-Output Economy with Trade and Financial Linkages of Firms

Abstract

Firms are connected through the production network. Meanwhile, the production linkages coincide with financial linkages owing to delays in input payments that amount to a form of trade credit. In this paper, I investigate the roles of these interconnected production and financial linkages in the propagation of financial shocks. Empirically, I find, based on the input-output matrix and loan data in the U.S., that the upstream propagation of financial shocks is stronger than their downstream propagation. Theoretically, I elaborate a model that can capture this pattern of shocks, of which trade credit is an important component. Moreover, the model reflects the fact that trade credit attenuates the propagation of financial shocks, through the sharing of liquidity, when shocks are relatively small and amplifies their propagation, through illiquidity contagion, when shocks are relatively large.