Production Network Structure, Service Share, and Aggregate Volatility

This paper studies differences in production structures across countries and their implications for cross-country heterogeneity in GDP volatility. In particular, economies with more input-output connections—a denser network—are associated with less concentrated sales shares and lower volatility. The relationship between density and volatility is stronger in countries with a higher share of services in GDP (hereafter referred to as service share). To account for this evidence, I propose a generalized production network model in which denser economies display higher production complexity. If production is also specialized in industries that use labor and intermediates as substitute inputs, higher network density indeed lowers the concentration of sales shares and aggregate volatility. U.S. sectoral data suggest that the elasticity of substitution between labor and intermediates in service sectors is larger than one and larger than in non-service sectors. A calibrated model that then also matches each country’s production network can quantitatively generate observed cross-country empirical patterns. Furthermore, in contrast to previous work, the model predicts that: i) sectoral shocks play only a modest role in accounting for the observed business cycle dynamics, especially in dense and service-oriented economies; and ii) production diversification does not always lower volatility.