From Micro to Macro: The Influence of Firm Heterogeneity on Foreign Shock Transmission

We investigate the role of firm heterogeneity and adjustment costs in the transmission of foreign supply shocks. Our starting point comes from a theoretical insight: If larger firms rely more on easily adjustable inputs, such as materials, then the aggregate output response to changes in the price of these inputs gets amplified relative to a representative firm economy. We next provide empirical evidence that larger firms are indeed more materials-intensive and more responsive to an exogenous foreign shock. We show that a New-Keynesian general equilibrium model with multiple sectors and firm heterogeneity is consistent with these facts. In line with the data, we find that firm heterogeneity amplifies the response of output and prices to a foreign supply shock but dampens the labor and GDP responses.