Coordinating Business Cycles

Abstract:We develop a quantitative theory of business cycles with coordination failures. Because of demand complementarities and increasing returns, firms seek to coordinate production and multiple equilibria arise. We use a global game approach to discipline equilibrium selection and show that the unique dynamic equilibrium exhibits multiple steady states. Coordination on high production may fail after a large transitory shock, pushing the economy in a quasi-permanent recession. Our calibrated model rationalizes various features of the 2007-2009 recession and its recovery. Government spending, while generally harmful, can increase welfare when the economy is transitioning between steady states. Other policy instruments are preferable to fix miscoordination.