Incomplete information and self-fulfilling prophecies

Pengfei Wang and Yi Wen

No 2007-033, Working Papers from Federal Reserve Bank of St. Louis

Abstract: This paper shows that incomplete information can be a rich source of sunspots equilibria. This is demonstrated in a standard dynamic general equilibrium model of monopolistic competition ? la Dixit-Stiglitz. In the absence of fundamental shocks, the model has a unique certainty (fundamental) equilibrium, but there are also multiple stochastic (sunspots) equilibria that are not mere randomizations over fundamental equilibria. In other words, sunspots can exist in infinite-horizon dynamic models with a unique saddle path steady state. In contrast to the recent sunspots literature (e.g., Benhabib and Farmer 1994), sunspots arising under incomplete information can be serially correlated and are robust to parameters associated with production technologies and preferences. Markup is always countercyclical in sunspots equilibria (which is consistent with empirical evidence) and fluctuations driven by sunspots look very similar to fluctuations driven by technology shocks.

Keywords: Business cycles; Prices (search for similar items in EconPapers)
Date: 2007
New Economics Papers: this item is included in nep-bec, nep-dge, nep-ict and nep-mac
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