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Increasing returns and optimal oscillating labor supply

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  • William D. Dupor
  • Andreas Lehnert

Abstract

Models featuring increasing returns to scale in at least one factor of production have been used to study two separate phenomena: (1) multiplicity of self-fulfilling rational expectations equilibria (i.e. sunspots), and (2) production schedules that optimally feature bunching. We show in a continuous-time model with increasing returns to labor (IRL) that if the economy features multiple competitive equilibria, the optimal path of investment, employment and consumption cannot be constant, or even smoothly-varying. Any macroeconomic policies that shielded the economy from sunspot fluctuations would necessarily not be optimal. We then characterize the optimal allocation (the solution to the planner's problem) in a discrete time version of the model. We find that the optimal investment, employment and consumption policies under increasing returns can feature (1) discontinuous jumps, (2) endogenous cycles (with time-varying cycle limits) and (3) stochastic controls (lotteries). Our discrete-time model is very close to that studied by Christiano and Harrison (1999); they, however find that fluctuations are not optimal. We show that this difference is driven by their assumption that production is linear in capital.

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Bibliographic Info

Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2002-22.

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Date of creation: 2002
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Handle: RePEc:fip:fedgfe:2002-22

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Related research

Keywords: Econometric models ; Labor supply;

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  17. Roger E.A. Farmer, 1994. "The Econometrics of Indeterminacy: An Applied Study," UCLA Economics Working Papers 720, UCLA Department of Economics.
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