Cascades of financial distortions in production network

Abstract

Sectoral financial distortions feature the structure of complex production network where distant sectors along a production chain can exhibit strong comovements. We construct a model of a CES production network with borrowing constraints to capture the cascading phenomena, and dissect the contagion and cascade of financial distortions with comparative statics under general equilibrium. We show that idiosyncratic financial distortions propagate through prices to downstream sectors, and further trigger changes in financial distortions, finally lead to a circular process with higher-order contagion and cascading. With U.S. data of sectoral credit spreads and production linkages, the patterns predicted by our model are empirically validated. Simulation with the calibrated model shows the existence of significant heterogeneity in the sectoral profile of financial spillovers, where the spillovers in Chemicals and F.I.R.E. sectors are more than those below their medians. Counterfactual simulations reveal that the macroeconomic importance of sectors needs substantial revision when financial cascade is taken into account.