Taste for variety and endogenous fluctuations in a monopolistic competition model

In past years, imperfect competition has been introduced in several dynamic models to show how mark-up variability, increasing returns (decreasing marginal cost) and monopoly profits affect the occurence of endogenous fluctuations. In this paper, we focus on another possible feature of imperfectly competitive economies: consumers' taste for variety due to endogenous product diversity. Introducing monopolistic competition (Dixit and Stiglitz (1977), Benassy (1996)) in an overlapping generations model where consumers have taste for variety, we show that local indeterminacy can occur under the three following conditions: a high substitution between capital and labor, increasing returns arbitrarily small and a not too elastic labor supply. The key mechanism for this result is based on the fact that, due to taste for variety, the aggregate price decreases with the pro-cyclical product diversity which has a direct influence on the real wage and the real interest rate