Resolving indeterminacy in dynamic settings: The role of shocks

This paper shows that the phenomenon of multiple equilibria can be fragile to the introduction of aggregate shocks. We examine a standard dynamic mode l of sectoral choice with external increasing returns. Without shocks, the outcome is indeterminate: there are multiple rational expectations equilibr ia. We then introduce shocks in the form of a parameter that follows a Brow nian motion and affects relative productivity in the two sectors. We assume that the parameter can reach values at which working in either sector beco mes a dominant choice. A unique equilibrium emerges; for any path of the ra ndom parameter, there is a unique path that the economy must follow. There is no role for multiple, self-fulfilling prophecies or sunspots.