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Ruling out indeterminacy: the role of heterogeneity

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  • Herrendorf, B.
  • Valentinyi, A.
  • Waldmann, R.

Abstract

Models with externalities have become increasingly popular for studying both long-term growth and business cycle fluctuations. Externalities can lead to indeterminacy, allowing self-fulfilling expectations to determine the equilibrium. This paper argues that the importance of indeterminacy might be overstated by the literature, as it does not recognize that heterogeneity across individuals can have a strong stabilizing effect. We illustrate this in a stylized two-sector economy with an externality by considering changes in the distribution of the individual entry costs into the two sectors. First, we find that the equilibrium is indeterminate (determinate) when the entry costs are relatively homogeneous (heterogeneous) across individuals. Our second result is that for any neighborhood of any possible long-run outcome of the economy, there is a mean preserving spread of the entry cost distribution such that the unique steady state lies in that neighborhood and is saddle-path stable. This implies that the aggregate characteristics may not be informative even when there is determinacy. So, indeterminacy is not necessary to explain the empirical fact that countries with very similar fundamentals can end up in rather different steady states.

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Bibliographic Info

Paper provided by Economics Division, School of Social Sciences, University of Southampton in its series Discussion Paper Series In Economics And Econometrics with number 9803.

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Date of creation: 01 Jan 1998
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Handle: RePEc:stn:sotoec:9803

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  1. Harris, Milton & Raviv, Artur, 1991. " The Theory of Capital Structure," Journal of Finance, American Finance Association, vol. 46(1), pages 297-355, March.
  2. Enrico C. Perotti & Octavian Carare, 1996. "The Evolution of Bank Credit Qulity in Transition: Theory and Evidence from Romania," William Davidson Institute Working Papers Series 49, William Davidson Institute at the University of Michigan.
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Cited by:
  1. Kiminori Matsuyama, 1999. "Playing Multiple Complementarity Games Simultaneously," Discussion Papers 1240, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  2. Paul Masson, 1999. "Multiple equilibria, contagion, and the emerging market crises," Proceedings, Federal Reserve Bank of San Francisco, issue Sep.

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