Firms and Farms: The Impact of Agricultural Productivity on the Local Indian Economy

Résumé

How do agricultural productivity shocks propagate through the local economy and affect firms? I develop a multi-sector general equilibrium model of the local rural economy to characterize how shocks to the farm sector are transmitted to manufacturing firms through factor and product markets. I combine firm, household and district-level data from India, and exploit weather-induced agricultural volatility, to estimate the response of local firms to agricultural productivity shocks. I show that firms respond to a negative shock by reducing production and employment. This holds true even though the local wage decreases, suggesting that local demand plays a key role for a large share of firms that produce locally-traded goods. I then examine whether the introduction of a large-scale rural workfare program affects the response of the local economy to agricultural volatility. I show that the program acts as a stabilization policy and attenuates the pro-cyclical response of local wage, consumption, and firms’ outcomes to agricultural productivity shocks. The results highlight the importance of cross-sector linkages for volatility in developing countries and underscore how rural development policies that target households can strongly affect the industrial sector because of general equilibrium effects.