Financial Shocks Propagation and International Trade Linkages

We use the production network approaches to show that the shocks on U.S. sectoral financing cost propagate through international trade linkages and drive the business cycles of Mexico. We take three steps to reach this conclusion. First, using a simple three-sector two-country model, we analytically show that U.S. financial shocks influence Mexican sectoral value-added by two channels. The price effect propagates through Mexican import network while the demand effect propagates through Mexican export network. Both effects transmit further via Mexican domestic production network. Secondly, utilizing a multiple-industry two-country model, we conduct structural factor model analysis and find that external financial shocks account for around 19% of the volatility of Mexico domestic output. Illustrated by impulse response functions, the demand effect dominates in the short run. Thirdly, employing the methodology in Acemoglu, Akcigit and Kerr (2016) to construct the "network effect" of shocks, we empirically test the role of trade linkages. The evidence on demand effect is prevalent but the evidence on price effect is mixed. More importantly, the interest-rate-driven demand effect not only propagate through Mexico export network but also transmit upward in Mexican domestic supply chain.