Consumer Demand Shocks and Firm Linkages: Evidence from Demonetization in India

Exploiting a unique natural experiment, the 2016 demonetization episode in India, this paper analyzes the extent to which a consumer demand shock propagates through firms’ input-output networks. In November 2016, India demonetized 86% of its currency, creating a nationwide demand shock. We construct measures of upstreamness to evaluate the impact of the demonetization shock on firms based on their position in the supply chain. Contrary to the predictions of many network models, we find that the shock does not meaningfully propagate across the supply chain. Revenues, wages, and investment decline substantially after demonetization, but these negative effects are largely limited to consumer facing firms. We identify several mechanisms, such as pricing power, inventory frictions, and export intensity, which independently explain this result. Our findings suggest that final goods producers are particularly susceptible to, and therefore must be protected against, unexpected declines in consumer demand.