Resolving Indeterminacy in Dynamic Settings: The Role of Shocks

David Frankel and Ady Pauzner

The Quarterly Journal of Economics, 2000, vol. 115, issue 1, 285-304

Abstract: 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.

Date: 2000
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