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In the presence of small market imperfections, the transitional dynamics of an open economy can become indeterminate, in that there exist an infinite number of equilibrium paths converging to a unique steady state. In contrast to closed economy models, in the open economy, such indeterminacy can arise independently of the curvature of the utility function in consumption. The results suggest that with market imperfections, open economies can be subject to fluctuations caused by randomness unrelated to the economy's fundamentals.

Are macroeconomic equilibria unique? A growing literature argues they are not and explores the possibility of indeterminacy and sunspots in dynamic general equilibrium economies with market imperfections.1 Indeterminacy means that from the same initial condition there exist an infinite number of equilibria, all of which converge to a common steady state. This allows for the existence of sunspot equilibria—that is, equilibrium allocations influenced by purely extrinsic beliefs unrelated to the economy's fundamentals (see, e.g., Cass and Shell, 1983 and Woodford, 1986). In turn, such sunspot equilibria provide a modern interpretation of Keynes's hypothesis that economic fluctuations are driven by the “animal spirits” of businessmen. Most models in the indeterminacy literature are closed economy. This has made it hard to satisfy the conditions necessary for generating indeterminacy. One issue has to do with technology. While early models relied on large increasing returns or large external effects to generate indeterminacy (e.g., Benhabib and Farmer, 1994), recent theoretical work, in particular in multisector models, demonstrates that only small market imperfections are required.2 The other issue has to do with preferences. These closed-economy models also require restrictions on the curvature on the utility function to generate indeterminacy. With small market imperfections, the models can only generate indeterminacy when the intertemporal elasticity of substitution in consumption is high—indeed, in some cases, the utility function has to be linear or close-to-linear in consumption.3 In short, there exists a tradeoff between the size of market imperfections and the magnitude of intertemporal elasticity of substitution needed for indeterminacy. The intuition for this tradeoff is easy to understand. Suppose there are two sectors in the closed economy: a consumption good sector and an investment good sector. Indeterminacy occurs if, while going along an equilibrium path, the representative agent decides to invest more and to jump onto an alternative path—and this turns out also to be an equilibrium, in that asset prices and returns then move in such a way as to make the jump optimal. But in the closed economy, for the agent to invest more, he must first curtail consumption. If the elasticity of intertemporal substitution in consumption is sufficiently low, doing so will be very costly, and the desire to smooth consumption may dominate the incentive to invest more, making the existence of an alternative equilibrium path impossible. In this paper, we focus on a small open economy model and investigate how and when indeterminacy can occur. Our main finding is that in an open economy, the conditions for indeterminacy can be satisfied more easily than in a closed economy. We show that in a two-sector small open economy with perfect access to a world bond market, indeterminacy can occur under very small or even negligible market imperfections, for technologies that exhibit constant marginal costs, and independently of the curvature of utility in consumption.4 These results suggest that in the presence of market imperfections, small open economies can be vulnerable to fluctuations caused by extrinsic uncertainty unrelated to the economy's fundamentals. The reason that indeterminacy can arise more easily in open economy models is straightforward. The proverbial representative agent who considers investing more and jumping to another equilibrium trajectory can do so without having to reduce consumption since he can always finance additional investment by borrowing from the outside world. The curvature of the utility function does not affect investment decisions, and indeterminacy can occur for any degree of intertemporal substitution. Only minimal market imperfection conditions in technology have to be satisfied. In all the examples of indeterminacy we construct below, the dynamic paths for investment and consumption are not unique, and therefore the current account and capital flows that finance it are also indeterminate. If sunspots move the economy from one equilibrium trajectory to another, then the capital and current accounts—and the associated prices—can be subject to sudden and potentially large movements governed by self-fulfilling prophecies. Such results are reminiscent of concerns often voiced in the policy literature: confronted with volatile capital flows and the resulting fluctuations in relative prices, analysts fret over the consequences and worry that such fluctuations may be the result of self-fulfilling prophecies. Some go as far as to advocate restrictions or at least gradualism in deregulating the capital account.5 Yet the theoretical foundations for such concerns are not always clear. To our knowledge, the first paper that studies indeterminacy in the open economy is Lahiri (2001). Unlike us, Lahiri is concerned with multiple growth paths in an endogenous growth model. In addition, his model relies on increasing returns (or decreasing marginal costs). Weder (2001) is closer in spirit to the present paper. But his model also depends on the unrealistic assumption of decreasing marginal costs to generate indeterminacy, while ours does not. Unlike Weder, we can also allow for traded capital in our framework. In addition, besides externalities we also analyze the effects of other kinds of market distortions—like factor taxation—in generating equilibrium indeterminacy. The paper is organized as follows. In Section 2, we consider a two-sector small open economy with production externalities.6 For simplicity, we assume that the consumption good is traded and the capital good is nontraded. In this setup we prove our main result: for the small open economy facing a perfect world bond market, indeterminacy can occur regardless of the degree of intertemporal substitution in consumption. Only a technological condition on the sectoral factor intensities is required. In Section 3, we extend the model in Section 2 in two directions. Our first extension shows that including traded capital does not alter the main result, and that a similar condition on the sectoral factor intensities is all that is needed for indeterminacy. In the second extension, we demonstrate that externalities are not necessary to obtain the indeterminacy result, and that other market distortions like factor taxation have the same effect. Section 4 concludes.

We have shown that, in the presence of market imperfections caused by externalities, it is easier for indeterminacy to occur in small open economies facing a perfect world bond market than in closed economies. The required externalities can be very small. Alternatively, other market distortions like factor taxation can have the same effect. An important implication of our analysis is that economies open to international and intertemporal trade may be more vulnerable to self-fulfilling beliefs than they would be in autarchy. One future task is to see whether plausible parametrization can generate the kinds of economic fluctuations that we observe in real-life economies. We plan to pursue this line of research in the future.