Indeterminacy with Small Externalities: The Role of Non-Separable Preferences

Abstract

In this paper we consider a Ramsey one-sector model with non-separable homothetic preferences, endogenous labour and productive external effects arising from average capital and labour. We show that indeterminacy cannot arise when there are only capital externalities but that it does when there are only labour external effects. We prove that sunspot fluctuations are fully consistent with small market imperfections and realistic calibrations for the elasticity of capital-labour substitution (including the Cobb-Douglas specification) provided the elasticity of intertemporal substitution in consumption and the elasticity of the labour supply are large enough.

Keywords: Indeterminacy, endogenous cycles, infinite-horizon model, endogenous labour supply, capital and labour externalities

JEL Classification: C62, E32, O41