Research Database

Capital accumulation and creative destruction is modeled together with risk-averse households. The novel aspect—risk-averse households—allows to use well-known models not only for analyzing long-run growth as in the literature but also short-run fluctuations. The model remains analytically tractable due to a very convenient property of the household’s investment decision in this stochastic continuous-time setup.

This paper identifies a novel form of dynamic inconsistency of stabilization policy in increasing returns models that generate multiple equilibria. We present a two-period version of the Benhabib-Farmer (1994) externalities model and derive closed-form solutions for all endogenous variables in every perfect foresight equilibrium. We provide conditions under which the stabilization policy that maximizes time zero consumer welfare is not time consistent. Furthermore, we characterize the time consistent stabilization policy. Our results cast doubts on the usefulness of government coordination of economic activity when the government lacks a commitment mechanism. Without commitment, a benevolent government can rule out multiplicity only by ensuring that a pareto dominated equilibrium obtains.