International Production Networks and the Propagation of Financial Shocks

Abstract

This paper investigates how external sector-level financial shocks are transmitted to a small open economy through international production networks. Using a multi-sector two-country model with asymmetric country size, I show analytically that a financial shock to the large country's production sector affects downstream sectors (through a price effect) and upstream sectors (through a direct demand effect and a complementarity or substitution effect). These effects work through international production networks, affecting the small country's output and GDP. Quantitatively, using simulation exercises and structural factor analyses, I show that U.S. sector-level financial shocks account for a significant fraction of the fluctuations in Mexico's GDP around the global financial crisis. International production networks amplify the real effect of external financial shocks by a factor greater than ten during the crisis.