The empirics of granular origins: some challenges and solutions with an application to the UK

Abstract

We study the effects of firm-level microeconomic fluctuations on aggregate productivity in the United Kingdom. We show that a standard measure of residual productivity growth of the largest UK firms (the ‘granular residual’) produces results that are partly counter-intuitive and statistically insignificant. To combat this, we propose a refinement to the widely used control function approach to estimating technology shocks in a production function, which is aimed at accounting for firm-level heterogeneity and the potential existence of common shocks. Using this approach, we find that idiosyncratic firm-level shocks matter for the UK; the ‘granular residual’ can explain around 30% of aggregate UK productivity dynamics. We also show that simplifications of our approach, which do not control for firm-level heterogeneity and the existence of common shocks, do not perform well empirically, highlighting the importance of identifying firm-specific shocks correctly in order to properly test the ‘granularity hypothesis’.