Industrial Connectedness and Business Cycle Comovements

While aggregate shocks account for most business cycle fluctuations, sectoral shocks have become relatively more important since the 1980s. Previous studies show that sectoral shocks propagate through industry supply chains. Typically, sectors are defined by similarities in function and/or market. While some industries have supply chains within their own sector (vertical), others have supply chains across a number of sectors (horizontal). Similarity in these supply chain characteristics appear to be a determining factor in how industries comove. Using industrial production data of 82 four-digit NAICS industries over the period 1972 to 2019, this comovement is analyzed in a panel Markov-switching model incorporating a number of features relevant for sub-national analysis: (i) industry-specific trends that differentiate cyclical downturns from secular declines; (ii) a national-level business cycle; and (iii) factors that represent industrial comovement. While national-level shocks are typically still the most important driver of cyclical fluctuations, endogenously clustering by industry comovement highlights the role of sectoral shocks.