Sunspots and Credit Frictions

By Sharon Harrison and Mark Weder

http://d.repec.org/n?u=RePEc:san:cdmawp:1001&r=dge

We examine a general equilibrium model with collateral constraints and increasing returns to scale in production. The utility function is nonseparable, with no income effect on the consumer’s choice of leisure. Unlike this model without a collateral constraint, we find that indeterminacy of equilibria is possible. Hence, business cycles can be driven by self-fulfilling expectations. This is the case for more realistic parametrizations than in previous, similar models without these features.

Models with increasing returns to scale have a nasty tendency for indeterminacy, as Roger Famer has shown. It was thought that introducing nonseparable utility was sufficient to prevent this (Jaimovich 2008, Meng and Yip 2008), but it appears that collateral constraints à la Kiyotaki and Moore (1997) make it reappear. This raises again the specter of self-fulfilling expectations and sunspots as possible sources of business cycles. In particular, would the last recession fit this description?

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