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Resolving Indeterminacy in Dynamic Settings: The Role of Shocks

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  • Frankel, David M.
  • Pauzner, Ady

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.

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Bibliographic Info

Paper provided by Iowa State University, Department of Economics in its series Staff General Research Papers with number 11924.

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Date of creation: 01 Jan 2000
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Publication status: Published in Quarterly Journal of Economics 2000,, pp. 283-304
Handle: RePEc:isu:genres:11924

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Postal: Iowa State University, Dept. of Economics, 260 Heady Hall, Ames, IA 50011-1070
Phone: +1 515.294.6741
Fax: +1 515.294.0221
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Web page: http://www.econ.iastate.edu
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