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Imperfect competition and sunspots

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Pengfei Wang
Yi Wen

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Abstract

This paper shows that imperfect competition can be a rich source of sunspots equilibria and coordination failures. This is demonstrated in a dynamic general equilibrium model that has no major distortions except imperfect competition. In the absence of fundamental shocks, the model has a unique certainty (fundamental) equilibrium. But there is also a continuum of stochastic (sunspots) equilibria that are not mere randomizations over fundamental equilibria. Markup is always counter-cyclical in sunspots equilibria, which is consistent with empirical evidence. The paper provides a justification for exogenous variations over time in desired markups, which play an important role as a source of cost-push shocks in the monetary policy literature. We show that fluctuations driven by self-fulfilling expectations (or sunspots) look very similar to fluctuations driven by technology shocks, and we prove that such fluctuations are welfare reducing.

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Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 2006-015.

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Date of creation: 2006
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Handle: RePEc:fip:fedlwp:2006-015

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Keywords: Equilibrium (Economics) ; Business cycles;

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