Combining the granular and network approaches to aggregate fluctuations

The desire to understand business cycle fluctuations, trade interdependencies and co-movement has a long tradition in economic thinking. Both theoretical and empirical studies have shown that a small number of entities such as firms or industries can have sizeable effects on aggregate economic fluctuations. One strand of recent literature focuses on the size of these “granular” entities, while another emphasizes the relevance of cascade effects that stem from significant asymmetries in the role of industries across the economic network. This study combines both approaches and empirically examines the contribution of industry-level idiosyncratic shocks to aggregate fluctuations in Europe. To perform our empirical analysis, we use the World Input-Output Database (WIOD). The WIOD consists of annual time series of World Input-Output Tables (WIOTs) covering, among others, all 28 EU countries for the period from 2000 to 2014. The analysis shows that shocks to large industries are of relevance, explaining roughly 20% of output fluctuations in the EU. This explanatory power increases considerably when controlling for sector-specific shocks. More importantly, when including the network perspective, the explanatory power increases to almost 80% of explained variance in GDP growth rates. We find that the European economy is indeed granular in industries and that combining the granular and network approaches significantly improves the explanatory power for the origins of aggregate fluctuations. Hence, aggregate fluctuations in the European economy seem not only to be dependent on the size of an industry but also on its position within the European production network.