Commodity Price Shocks and Production Networks in Small Open Economies

We study the role of domestic production networks in the transmission of commodity price shocks in small open economies. We provide empirical evidence of a strong propagation of commodity price shocks to quantities produced in domestic sectors that supply intermediate inputs to commodity sectors (upstream propagation) and a muted propagation to sectors using commodities as intermediate inputs (downstream propagation). We develop a small open economy production network model to explain these transmission patterns. We show that the domestic production network is crucial in shaping the propagation of commodity prices. The two key mechanisms that rationalize the evidence are i) the foreign demand channel and ii) the input-output substitution channel. These two channels amplify the upstream propagation of commodity price changes, by increasing the demand for noncommodity inputs, and, at the same time, they mitigate the downstream cost channel by allowing firms to use relatively cheaper primary inputs in production.