Self - Fulfilling Prophecies

After a quarter century of unbroken development in the theory of allocation under uncertainty, it has become an obvious fact that randomness in endowments, preferences or technology will generally work its way to the prices and allocations which prevail in equilibrium. Is it true, as intuition may suggest in haste, that random prices necessarily reflect some intrinsic uncertainty in the structure of the economy, or can they arise, as some recent literature [3, 12, 14, 151 indicates, merely from extraneous, self-perpetuating beliefs that prices are stochastic? The question is of interest for it raises the possibility that business cycles are set in motion by arbitrary shifts in any factor, however purely subjective, agents happen to deem relevant to economic activity: animal spirits, consumer sentiment or the prophecies of the Sibyl at Cumae may spark fluctuations in which prices change simply because they are expected to and price signals convey no structural information. The evidence on the influence of subjective factors is ample and dates back several centuries’; the Dutch “tulip mania,” the South Sea bubble in England, and the collapse of the Mississippi Company in France are three well-documented cases of speculative price movements which historians consider unwarranted by “objective” conditions. What follows is a demonstration that a kindred type of paradoxical behavior, which we name extraneous uncertainty, is both possible and “frequent” among rational expectations equilibria in an aggregative model of overlapping generations. In particular, if we constrain (the probability distribution of) the price level to clear markets, reproduce beliefs and, in