Financial Frictions in Production Networks

We show that the organization of production among firms in an economy has important implications for the impact of financial frictions. We set up a model in which firms use output of other firms as inputs for their own production. We allow for arbitrary network structures such that aggregate production functions are constant. Therefore, in the absence of frictions these structures are allocatively equivalent. We then provide several examples which illustrate that when firms face liquidity constraints, different input-output structures require vastly di§erent amounts of aggregate liquidity in order to implement identical allocations. This implies that the input-output structure of the economy is an important determinant of its response to a financial shock. Our main result is that financial constraints have a stronger impact on aggregate output when firms are engaged in a larger amount of transactions among themselves. Finally, we calibrate the model to match the input-output matrix of the U.S. economy and use this to explore the extent to which these interrelationships can explain the drop in output during the latest recession.