Business Cycles with Free Entry Ruled by Animal Spirits

Working Paper: CEPR ID: DP3919

Authors: Rodolphe Dos Santos Ferreira; Teresa Lloyd-Braga

Abstract: The Paper approaches business cycles in terms of extrinsic uncertainty related, not to dynamic indeterminacy of intertemporal equilibria (in the neighborhood of an attractor) or to multiplicity of steady states (in non-linear models), but to static indeterminacy of free entry oligopolistic equilibria within each period. We consider an OLG economy in which firms, supplying differentiated goods within each one of many sectors, and producing under increasing returns-to-scale, compete in prices in perfectly contestable markets. The number of active firms is shown to vary across sectoral equilibria, depending upon the (correct) producers? conjectures on the actions of their competitors. These conjectures are assumed to be coordinated by some extrinsic Markov chain, thus generating endogenous shocks in both the markup factor and productivity, and resulting in perturbations of the dynamic system (as in the case of exogenous random shocks). Consumers? expectations may magnify the extrinsic uncertainty characterizing producers? conjectures. Since the source of fluctuations does not rely on dynamic indeterminacy, we can weaken the condition on the degree of increasing returns, which may be arbitrarily small (with a moderate positive elasticity of labour supply), provided goods substitutability within each sector becomes arbitrarily large.

Keywords: animal spirits; business cycles; free entry; indeterminacy; oligopoly; sunspots

JEL Codes: D43; E32; L10

Causal Claims

Cause	Effect
producers' conjectures about competitors' actions (D43)	number of active firms (L25)
consumer expectations (D84)	number of active firms (L25)
external shocks (F69)	number of active firms (L25)
number of active firms (L25)	fluctuations in business cycles (E32)
shocks in consumer expectations (D12)	fluctuations in business cycles (E32)