Imperfect Competition and Sunspots

This paper shows that imperfect competition can be a rich source of sunspots equilibria and coordination failures. This is demonstrated in a dynamic general equilibrium model that has no major distortions except imperfect competition. In the absence of fundamental shocks, the model has a unique certainty (fundamental) equilibrium. But there is also a continuum of stochastic (sunspots) equilibria that are not mere randomizations over fundamental equilibria. Markup is always counter-cyclical in sunspots equilibria, which is consistent with empirical evidence. The paper provides a justi…cation for exogenous variations over time in desired markups, which play an important role as a source of cost-push shocks in the monetary policy literature. We show that ‡uctuations driven by self-ful…lling expectations (or sunspots) look very similar to ‡uctuations driven by technology shocks, and we prove that such ‡uctuations are welfare reducing. Keywords: Sunspots, Self-ful…lling Expectations, Imperfect Competition, Imperfect Information, Indeterminacy, Real Business Cycles, Marginal Costs, Counter-cyclical Markup. JEL codes: E31, E32. We thank Jess Benhabib, Karl Shell, and seminar participates at Cornell University for comments, and John McAdams for research assistance. The views expressed in the paper and any errors that may remain are the authors’ alone. Correspondence: Yi Wen, Research Department, Federal Reserve Bank of St. Louis, St. Louis, MO, 63144. Phone: 314-444-8559. Fax: 314-444-8731. Email: [email protected].