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Increasing Returns to Scale and Welfare: Ranking the Multiple Deterministic Equilibria

We consider a real business cycle model with a productive externality and an aggregate non- convex technology set µa la Benhabib and Farmer embodying capacity utilization, which exhibits indeterminacy of the steady state and multiplicity of deterministic equilibria under plausible values of the increasing returns to scale. The aim of the paper is to rank these different equilibria according to the initial value of consumption using both a linear-quadratic approximation, extensively explained by Benigno and Woodford [2006a, 2006b], and simulation methods. We study the implications of such a ranking in terms of smoothness of the welfare-maximizing trajectory and show that the welfare- maximizing consumption and labor paths are all the smoother since the level of increasing returns is low. At last, we show that this solution provides a good benchmark for judging the desirability of the stabilization policy proposed by Guo and Lansing [1997].

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File URL: https://www.ethz.ch/content/dam/ethz/special-interest/mtec/cer-eth/cer-eth-dam/documents/working-papers/wp_08_99.pdf
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Paper provided by CER-ETH - Center of Economic Research (CER-ETH) at ETH Zurich in its series CER-ETH Economics working paper series with number 08/99.

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Length: 21 pages
Date of creation: Oct 2008
Date of revision:
Handle: RePEc:eth:wpswif:08-99
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  1. Benigno, Pierpaolo & Woodford, Michael, 2006. "Linear-Quadratic Approximation of Optimal Policy Problems," CEPR Discussion Papers 5964, C.E.P.R. Discussion Papers.
  2. Russell, Thomas & Zecevic, Aleksandar, 1998. "Lyapunov stability, regions of attraction, and indeterminate growth paths," Economics Letters, Elsevier, vol. 58(3), pages 319-324, March.
  3. Nadiri, M Ishaq & Prucha, Ingmar R, 1996. "Estimation of the Depreciation Rate of Physical and R&D Capital in the U.S. Total Manufacturing Sector," Economic Inquiry, Western Economic Association International, vol. 34(1), pages 43-56, January.
  4. Lawrence J. Christiano & Sharon G. Harrison, 1996. "Chaos, Sunspots, and Automatic Stabilizers," NBER Working Papers 5703, National Bureau of Economic Research, Inc.
  5. Benhabib, Jess & Farmer, Roger E.A., 1996. "Indeterminacy and Sector-Specific Externalities," Working Papers 96-12, C.V. Starr Center for Applied Economics, New York University.
  6. Benigno, Pierpaolo & Woodford, Michael, 2006. "Optimal taxation in an RBC model: A linear-quadratic approach," Journal of Economic Dynamics and Control, Elsevier, vol. 30(9-10), pages 1445-1489.
  7. Jess Benhabib & Roger E.A. Farmer, 1992. "Indeterminacy and Increasing Returns," UCLA Economics Working Papers 646, UCLA Department of Economics.
  8. Russell, Thomas & Zecevic, Aleksandar, 2000. "Indeterminate growth paths and stability," Journal of Economic Dynamics and Control, Elsevier, vol. 24(1), pages 39-62, January.
  9. Stephanie Schmitt-Grohe & Martin Uribe, 2001. "Solving Dynamic General Equilibrium Models Using a Second-Order Approximation to the Policy Function," Departmental Working Papers 200106, Rutgers University, Department of Economics.
  10. Guo, Jang-Ting & Lansing, Kevin J., 1998. "Indeterminacy and Stabilization Policy," Journal of Economic Theory, Elsevier, vol. 82(2), pages 481-490, October.
  11. Magill, Michael J. P., 1977. "A local analysis of N-sector capital accumulation under uncertainty," Journal of Economic Theory, Elsevier, vol. 15(1), pages 211-219, June.
  12. Jang-Ting Guo & Sharon G. Harrison, 2001. "Tax Policy and Stability in a Model with Sector-Specific Externalities," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 4(1), pages 75-89, January.
  13. Hansen, Gary D., 1985. "Indivisible labor and the business cycle," Journal of Monetary Economics, Elsevier, vol. 16(3), pages 309-327, November.
  14. Greenwood, Jeremy & Hercowitz, Zvi & Huffman, Gregory W, 1988. "Investment, Capacity Utilization, and the Real Business Cycle," American Economic Review, American Economic Association, vol. 78(3), pages 402-17, June.
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