RIETI Report April 2014

Geography, Idiosyncratic Shocks, and Aggregate Fluctuations

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Economies experience a variety of local shocks including industry shocks as industries are unevenly distributed in space. Many of these local shocks are too small to affect the aggregate economy but have an impact that goes beyond the very town, firm, or industry that it affects directly. However, other shocks can have widespread effects on states, other sectors, and, importantly, the aggregate economy. In the April issue of the RIETI Report, we present "Geography, Idiosyncratic Shocks, and Aggregate Fluctuations" written by Princeton University Professor Esteban Rossi-Hansberg for our Perspectives from Around the World section.

Professor Rossi-Hansberg first gives an overview of the convincing evidence of idiosyncratic shocks in generating aggregate fluctuations and provides some analysis of the research done on the effects of industry shocks on aggregate outcome. However, a critical dimension, space, is missing in this process. He proposes a framework using a rich dataset to develop a model--taking space into account--that can be used to quantify the effects of local and sectoral shocks on aggregate and local outcomes; currently it is used only for the United States but can be readily applied to a variety of countries including Japan. Finally, it is Professor Rossi-Hansberg's hope that this type of quantitative exercise will be repeated for other countries in the future, of particular interest would be Japan with its weather shocks, and furthermore, the concentration of the Japanese economy in sectors such as Computers and Electronics make the above exercise particularly revealing.

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Geography, Idiosyncratic Shocks, and Aggregate Fluctuations

Esteban ROSSI-HANSBERG Professor, Princeton University

Economies experience a variety of local shocks: Natural disasters and weather related disruptions, discoveries of natural resources, disruptions of particular trade routes, corporate bankruptcies and other shocks to local firms, and labor strikes are a few examples. Moreover, industry shocks are local since industries are unevenly distributed in space. Many of these local shocks are too small to affect the aggregate economy and to have an impact that goes beyond the very town, firm, or industry that it affects directly. However, other shocks can have widespread effects on states, other sectors, and, importantly, the aggregate economy.

Japan experienced this first-hand with the economic effect of the earthquake and tsunami, as did cities like New Orleans in the case of Hurricane Katrina, or states like Michigan with the troubles of U.S. automakers, or California with inventions in the high-tech industry. Examples of local shocks abound, but do these shocks have sizable aggregate implications? Can we gauge and measure the effect of these shocks on aggregate outcomes? What does the elasticity of aggregate productivity, output, and employment depend on? Understanding the answer to these questions is essential for the design of policies to alleviate and manage the effect of shocks to the economy.

To read the full text
http://www.rieti.go.jp/en/special/p_a_w/041.html

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