Ebook Factor Demand Linkages, Technology Shocks and the Business Cycle
Input output linkages are a pervasive feature of modern economies. Neglecting them could lead to a significant loss in understanding the dynamics of the supply side of an economy. Intermediate goods used in one sector are produced in other sectors, which in turn use the output from the first sector as an input to their own production. Therefore there are complex circular networks of input output interactions that need to be taken into account. The presence of an intermediate input channel is emphasized by Hornstein and Praschnik (1997) and recently analyzed in detail in Kim and Kim (2006).
In this paper we consider explicitly the empirical relevance of this channel. We study fluctuations at the sectoral and the aggregate level and we show that it is important to model the interactions between sectors if we want to fully understand the propagation of shocks across the economy. Typically, reduced form time series methods, in conjunction with the long run identifying assumptions, are used to disentangle disturbances to an economy. With few exceptions, the literature has applied these methods to aggregate time series. However, modelling aggregate time series directly implies that sectors are relatively homogeneous and most importantly, that interactions among sectors are of second order importance for aggregate fluctuations.
Following the pioneering work of Long and Plosser (1983), RBC models have been generalized into a multisectoral environment where industry specific shocks are propagated through sectoral inter dependencies which can generate business cycle fluctuations. The idea was revitalized by Horvath (1998, 2000) who shows how the input output structure of the economy is a good way of capturing the relations between sectors in the economy. Also, Conley and Dupor (2003) and Shea (2002) emphasize sectoral complementarities as the main mechanism for propagating sectoral shocks at the aggregate level, the main idea being intrinsically related to the original result of Jovanovic (1987).
We proceed by modelling the dynamics of a panel of highly disaggregated manufacturing sectors. We assume that industry dynamics are mainly driven by technology and non technology shocks. We use a simplified version of a multi sectoral real business cycle with factor demand linkages to derive restrictions that allow us to understand how shocks from one sector can affect productivity in other sectors. Those long run restrictions are then used in a structural VAR in order to identify the shocks. We then construct an industry VAR (SecVAR) using the GVAR approach of Pesaran et al. (2004) and link sectors through the input output matrix.
The main novelty is that all sectors in the economy are related by factor demand linkages captured by the input output matrix. This allows us to distinguish between the contribution made by technology shocks to particular sectors and the overall effect amplified by sectoral interactions. Therefore, for each sector we identify technology and non technology shocks, where these shocks alone can explain industry and aggregate fluctuations only if all sectors are analyzed contemporaneously, i.e. not in isolation. We establish that the intermediate input channel is crucial for propagating shocks to the aggregate economy.
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