Business cycles with free entry ruled by animal spirits

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 nonlinear models), but to static indeterminacy of free entry oligopolistic equilibria within each period. We consider an OLG economy in which Þrms, 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 Þrms 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 ßuctuations 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 labor supply), provided goods substitutability within each sector becomes arbitrarily large. JEL classiÞcation number: D43, E32, L1