Coordinating Business Cycles

Abstract

We develop a dynamic stochastic general equilibrium model of business cycles with coordination failures. Because of an aggregate demand externality, firms only want to produce when other firms do as well. The presence of variable capacity utilization leads to multiple equilibria under perfect information. Under imperfect information, the equilibrium is unique and the economy endogenously fluctuates between a good regime--high output, employment and investment--and a bad regime with low output, employment and investment. Under some conditions, the economy exhibits coordination traps: after a series a bad shocks, the state of the economy is too depressed for firms to be able to coordinate on the high equilibrium and recessions may persist for an extended duration, consistent with features of secular stagnations. We use the model to analyze the impact of stabilization policies. Without additional frictions, fiscal interventions are detrimental to coordination. Optimal policy interventions take the form of production subsidies.