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Increasing Returns and Unsynchronized Wage Adjustment in Sunspot Models of the Business Cycle

  • Kevin X.D. Huang

    ()

    (Department of Economics, Vanderbilt University)

  • Qinglai Meng

    ()

    (Department of Economics, Oregon State University, Department of Economics, Chinese University of Hong Kong)

A challenge facing the literature of equilibrium indeterminacy and sunspot-driven business cycle fluctuations based on increasing returns to scale in production is that the required degree of increasing returns for generating indeterminacy can be implausibly large and rise quickly with the relative risk aversion in labor. We show that unsynchronized wage adjustment via a relative wage effect can both lower the required degree of increasing returns for indeterminacy to an empirically plausible level and make it invariant to the relative risk aversion in labor. As a result, indeterminacy and sunspot-driven business cycle fluctuations may emerge for empirically plausible increasing returns regardless of the value of the relative risk aversion in labor. The impulse responses of our model to demand shocks under indeterminacy are reasonable in terms of matching the business cycle, and sunspot shocks become more important due to the presence of labor market frictions.

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Paper provided by Vanderbilt University Department of Economics in its series Vanderbilt University Department of Economics Working Papers with number 1007.

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Date of creation: Mar 2010
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Handle: RePEc:van:wpaper:1007
Contact details of provider: Web page: http://www.vanderbilt.edu/econ/wparchive/index.html

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