Academic journal article Economic Inquiry

Strategic Complementarity Slows Macroeconomic Adjustment to Temporary Shocks

Academic journal article Economic Inquiry

Strategic Complementarity Slows Macroeconomic Adjustment to Temporary Shocks

Article excerpt

I. INTRODUCTION

Starting with the work Of Diamond [1982], Hart [1982], and Bryant [1983], a number of authors have employed models which use potential coordination failure to show that many features of the Keynesian framework can be captured in models consistent with the microfoundations approach.(1) For example, in the context of a search model Diamond demonstrates the existence of equilibria with "too low" a level of aggregative activity, Hart captures this feature and the simultaneous existence of multipliers in a model of monopolistic competition, while technological interactions are the crucial element of Bryant's analysis. One reason to refer to these seemingly diverse set of papers as a single literature is that all the models are in fact driven by the presence of the same factor: strategic complementarity. A macroeconomic model which exhibits strategic complementarity is simply one where, the larger is aggregate production, the larger is the incentive for any particular agent to produce. Cooper and John [1988] first demonstrated that the presence of strategic complementarity is a characteristic of all of the models mentioned above, and persuasively argue that this is the critical feature which lies behind the finding of Keynesian-type results.

In this paper we argue that strategic complementarity is also important in understanding the dynamic response of economies to temporary shocks. In particular, we find that strategic complementarity is potentially an important factor in understanding why an economy may return only slowly to steady-state behavior after a temporary shock. That is, given the presence of any of a variety of factors which would cause the economy not to instantaneously return to full employment after a temporary shock (e.g., adjustment costs associated with changing the capital stock), the speed with which the economy returns to steady-state behavior is negatively related to the degree of strategic complementarity in the environment.

Related analyses are those of Haltiwanger and Waldman [1989], Bomfim and Diebold [1992], and Baxter and King [1990]. The first two papers consider models wherein some agents are characterized by adaptive or regressive expectations while others am characterized by rational expectations. Among other findings, these analyses demonstrate that the speed with which the economy returns to steady-state behavior after a temporary shock is negatively related to the degree of strategic complementarity in the economy.(2) We argue that the relationship between strategic complementarity and the dynamic response to temporary shocks is more general than is suggested by these papers. In their analyses temporary shocks have long-term effects because some of the agents make systematic mistakes when forming expectations. Here it is argued that, given any of a variety of factors which would cause temporary shocks to have long-term effects, there is a negative relationship between adjustment speed and the degree of strategic complementarity.

Baxter and King consider a world where, because of productive externalities, the economy exhibits increasing returns at the economy-wide level. Using simulation techniques they show, first, that the presence of increasing returns serves to increase the output volatility exhibited by the economy in response to shocks and, second, that after a one-time shock the return to steady-state behavior is slower in a world characterized by increasing returns. Baxter and King do not discuss their results in terms of strategic complementarity. However, it is easy to show that one way of introducing strategic complementarity is to assume that the economy exhibits increasing returns at the economy-wide level. Our paper suggests that what is central in Baxter and King's study is not the introduction of increasing returns per se, but rather that the introduction of increasing returns is one way of introducing strategic complementarity. That is, Baxter and King's findings can be thought of as a manifestation of the central point of the current paper. …

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