Essays On Networks In Macroeconomics And Finance

Wu Zhu, University of Pennsylvania


This thesis consists of three essays that examine theoretically and empirically the implications of networks in business cycles, economic recovery, systemic risk, corporate finance and governance, and asset pricing.

This first chapter emphasizes the role of networks in driving economic recovery from recessions and its role in asset pricing. It is based on a joint work with Yucheng Yang. The speed at which the US economy has recovered from recessions ranges from months to years. We propose a model incorporating the innovation network, the production network, and cross-sectional shocks and show that their interactions jointly explain large variations in the recovery speed across recessions in the US. We show that when the innovation network has low-rank, there exists one key direction: the impact of a shock becomes persistent only if the shock is parallel to this key direction; in contrast, the impact diminishes quickly if the shock parallels to other directions. Empirically, we estimate the model in a state-space form and document a set of new stylized facts of the US economy. First, the innovation network among sectors has low-rank. Second, the innovation network has non-negligible overlap with the production network. Third, recessions with slow recovery are those witnessing sizable negative shock to sectors central to the innovation network. Such network structures and the time-varying sectoral distribution of the shocks can well explain the large variation in the recovery speed across recessions in the US. Finally, we show that the force driving a slow-recovery yields a small but persistent process in consumption growth, and we use this process to explain several puzzles in asset pricing.

The second chapter is based on the joint work with Yiqing Xing and Rakesh Vohra where we explore the agency conflicts in amplifying and propagating a shock in equity cross-holding networks. Unlike the first chapter, here, we emphasize the role of financial network and agency conflicts within the firm. We argue that firm-level agency conflicts and not just the network of interdependencies between firms, play a crucial role in amplifying or muting the propagation of exogenous shocks. Suppose firms can make investment decisions in response to an exogenous shock. If they are subject to default costs or limited liability, their investment decisions mitigate the spread of an initial shock. In the face of interest conflicts or moral hazard, firm-level investment choices amplify an initial shock. Agency conflicts counter the role of network structure in the propagation of shocks. For example, prior work argues that more integrated networks facilitate the propagation of shocks. In the presence of interest conflicts, this effect can be reversed. Under some condition, in a fully diversified network, the aggregate effect of an idiosyncratic shock via propagation does not diminish. This suggests a potentially important role that corporate governance plays in macro fluctuations.

The third chapter is based on the joint work with Yu Shi and Robert Townsend where we show the business groups can significantly change the effect of credit supply shock through the equity-holding networks. Using business registry data from China, we show that internal capital markets in business groups can play the role of a financial intermediary and propagate corporate shareholders’ credit supply shocks to their subsidiaries. An average of 10% local bank credit growth where corporate shareholders are located would increase subsidiaries' investment by 0.6% of their tangible fixed asset value, which accounts for 42.5% (4.3%) of the median (average) investment rateamong these firms. We argue that equity exchanges is one channel through which corporate shareholders transmit bank credit supply shocks to the subsidiaries and provide evidence to support the channel.