International production networks and the propagation of financial shocks

This paper investigates how external sector-level financial shocks are transmitted to a small open economy through international production networks. Using a multi-sector small open economy model, I show analytically that a financial shock to an external 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, I construct U.S. sector-level excess bond premia and estimate key parameters for simulations. The simulation exercises show that U.S. financial shocks account for a significant proportion of the fluctuations in Mexico’s GDP during the global financial crisis. International production networks amplify the real effect of external financial shocks by a factor of at least three during the crisis.