Propagation of financial shocks in an input-output economy with trade and financial linkages of firms

Abstract Firms are connected through the production network, in which the production linkages coincide with financial linkages owing to delays in input payments that amount to a form of trade credit. In this paper, I investigate the roles of these interconnected production and financial linkages in the propagation of financial shocks. Empirically, I find, based on U.S. input-output matrix and loan data, that the upstream propagation of financial shocks is stronger than the downstream propagation. Theoretically, I elaborate a model that can capture this pattern of shocks, of which trade credit is an important component. Moreover, the model reflects the fact that trade credit attenuates the propagation of financial shocks when shocks are relatively small through the sharing of liquidity and amplifies their propagation when shocks are relatively large through illiquidity contagion.