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Ruling out indeterminacy: the role of heterogeneity

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

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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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. Rajan, Raghuram G & Zingales, Luigi, 1995. " What Do We Know about Capital Structure? Some Evidence from International Data," Journal of Finance, American Finance Association, vol. 50(5), pages 1421-60, December.
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  5. Steven M. Fazzari & R. Glenn Hubbard & BRUCE C. PETERSEN, 1988. "Financing Constraints and Corporate Investment," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 19(1), pages 141-206.
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  8. Michael Devereux & Fabio Schiantarelli, 1990. "Investment, Financial Factors, and Cash Flow: Evidence from U.K. Panel Data," NBER Chapters, in: Asymmetric Information, Corporate Finance, and Investment, pages 279-306 National Bureau of Economic Research, Inc.
  9. Schiantarelli, Fabio, 1996. "Financial Constraints and Investment: Methodological Issues and International Evidence," Oxford Review of Economic Policy, Oxford University Press, vol. 12(2), pages 70-89, Summer.
  10. Berglöf, Erik & Roland, Gérard, 1995. "Bank Restructuring and Soft Budget Constraints in Financial Transition," CEPR Discussion Papers 1250, C.E.P.R. Discussion Papers.
  11. Harris, Milton & Raviv, Artur, 1991. " The Theory of Capital Structure," Journal of Finance, American Finance Association, vol. 46(1), pages 297-355, March.
  12. Schaffer, Mark E., 1998. "Do Firms in Transition Economies Have Soft Budget Constraints? A Reconsideration of Concepts and Evidence," Journal of Comparative Economics, Elsevier, vol. 26(1), pages 80-103, March.
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