1997 Articles

Self-fulfilling Prophecies and the Business Cycle

Farmer, Roger E. A.; Woodford, Michael

We demonstrate that multiple stationary rational-expectations equilibria exist in a version of Lucas's island economy. The existence of these equilibria follows from the fact that there is an indeterminate set of monetary equilibria in the two-period overlapping-generations model. We show how to construct stationary rational-expectations equilibria by randomizing over the set of nonstationary monetary equilibria. In some of our equilibria, a positively sloped Phillips curve exists even though our economy contains no signal-extraction problem as in the original Lucas paper. Our equilibria are indexed by beliefs and are examples of the existence of sunspot equilibria in which allocations may differ across states of nature for which preferences, technology, and endowments are identical. Our technique for constructing stationary sunspot equilibria should prove useful in a wide class of models in which an indeterminate stationary equilibrium exists.