By Mathieu Taschereau-Dumouchel and Edouard Schaal
We develop a quantitative theory of business cycles with coordination failures. Because of a standard aggregate demand externality, firms want to coordinate production. The presence of a non-convex capacity decision generates multiple equilibria under complete information. We use a global game approach to show that, under incomplete information, the multiplicity of equilibria disappears to give rise to a unique equilibrium with two stable steady states. The economy exhibits coordination traps: after a negative shock of sufficient size or duration, coordination on the good steady state is harder to achieve, leading to quasi-permanent recessions. In our calibration, the coordination channel improves on the neoclassical growth model in terms of business cycle asymmetries and skewness. The model also accounts for features of the 2007- 2009 recession and its aftermath. Government spending is harmful in general as the coordination problem magnifies the crowding out. It can, however, increase welfare — without nominal rigidities — when the economy is about to transition to the bad steady state. Simple subsidies implement the efficient allocation.
This is an interesting way to approach coordination failures and how to narrow down the set of possible equilibria. And for those who feel that the fundamentals were right in the economy, at least on the real side, this model can provide an explanation why a deep and long recession still resulted from a financial shock. The paper ignores completely, though, the impact of very low real interest rates, like the Fed has been pursuing. I wonder whether this model is telling us this policy is a good way to get to the better equilibrium. It should certainly help with coordination.