Resolving Indeterminacy In Dynamic Settings: The Role Of Shocks
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. © 2000 the President and Fellows of Harvard College and the Massachusetts Institute of Technology
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Volume (Year): 115 (2000)
Issue (Month): 1 (February)
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