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Resolving Indeterminacy in Dynamic Settings: The Role of Shocks

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  • David Frankel
  • Ady Pauzner

Abstract

This paper shows that the phenomenon of multiple equilibria can be fragile to the introduction of aggregate shocks. We examine a standard dynamic model of sectoral choice with external increasing returns. Without shocks, the outcome is indeterminate: there are multiple rational expectations equilibria. We then introduce shocks in the form of a parameter that follows a Brownian motion and affects relative productivity in the two sectors. We assume that the parameter can reach values at which working in either sector becomes a dominant choice. A unique equilibrium emerges; for any path of the random parameter, there is a unique path that the economy must follow. There is no role for multiple, self-fulfilling prophecies or sunspots.

Suggested Citation

  • David Frankel & Ady Pauzner, 2000. "Resolving Indeterminacy in Dynamic Settings: The Role of Shocks," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 115(1), pages 285-304.
    • Handle: RePEc:oup:qjecon:v:115:y:2000:i:1:p:285-304.
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    File URL: http://hdl.handle.net/10.1162/003355300554746
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