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Idiosyncratic shocks and the role of granularity in business cycle

Author

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  • Tatsuro Senga

    (Queen Mary University of London)

  • Iacopo Varotto

    (Queen Mary University of London)

Abstract

Idiosyncratic shocks faced by large firms in the U.S. appears to be volatile. Such idiosyncratic shocks may not average out in the cross-section and thus can even generate aggregate fluctuations. In this paper, we first construct a panel of US firms using data from Compustat and show a set of stylized facts about cross-sectional and cyclical features of idiosyncratic shocks faced by large firms. Our panel data reveals that the mean and kurtosis of idiosyncratic shocks decrease with firm size, while the standard deviation and skewness increase with firm size. In particular, the distribution of idiosyncratic shocks faced by the largest firms has a negative mean and positive skew. We also show that the mean of idiosyncratic shocks faced by the largest firms is significantly countercyclical. To examine the quantitative importance of such features of idiosyncratic shocks faced by large firms, we then develop an equilibrium business cycle model wherein idiosyncratic shocks can alone alter the shape of the distribution of firms and thus can drive aggregate fluctuations. We develop a general framework to study such models, wherein the law of large number does not hold and the distribution of firms over productivities becomes a random object, rendering infeasible the use of a standard numerical method. The flexibility of this new approach allows us to isolate the two channels through which the idiosyncratic movements of the firms generate aggregate volatility: average productivity and dynamic inefficiency. In addition we quantify the relative importance of the shocks to large firms in driving the cycle. The model is estimated to match micro-level moments of firm size distribution and idiosyncratic shocks, together with standard macro moments. Consistent with existing studies, our results show that idiosyncratic shocks are a quantitatively important micro-origin of aggregate fluctuations, accounting for 25 percent of output volatility relative to the data. Large firm movements account for 11 percent of aggregate volatility, wherein 63 percent reflects dynamic inefficiency channel.

Suggested Citation

  • Tatsuro Senga & Iacopo Varotto, 2018. "Idiosyncratic shocks and the role of granularity in business cycle," 2018 Meeting Papers 1012, Society for Economic Dynamics.
    • Handle: RePEc:red:sed018:1012
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    References listed on IDEAS

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