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

Because of delays to input payments, production linkages coincide with trade credit linkages. This paper investigates how these interconnected production and financial linkages of firms propagate shocks upstream and downstream in an input-output model. Theoretically, I obtain that financial frictions in trade and financial linkages of firms are necessary features for generating strong upstream propagation of financial shocks. Meanwhile, four types of firm level heterogeneities play important roles in firm’s sensitivity to shocks: 1) the positions in the production network, 2) the levels of liquidity constraints, 3) the degrees of mismatching maturities, in terms of accounts-payables and accounts-receivables, and 4) the forms of production functions. Empirically, I observe that upstream propagation of financial shocks is stronger than downstream propagation in the U.S. data, which conforms to my theoretical prediction. Finally, I use the model to compare credit policies that target liquidity to different sectors. I show that after an aggregate liquidity shock credit policies have a stronger impact by supplying liquidity to downstream sectors.