On Indeterminacy in Two Sector Models with Factor Market Distortions: The Importance of VIPIRS

Abstract

Previous literature has shown that local indeterminacy and local instability can arise in two-sector models when factor market distortions create a divergence between capital intensity ranking of the sectors on a physical basis and on a value basis. We identify a previously unnoticed source of indeterminacy that arises when there are value intensity - physical intensity reversals (VIPIRs), which is that there is a range of the phase plane in which there are 3 static equilibria (one with incomplete specialization and one with complete specialization in each of the respective goods). We show how this multiplicity of equilibria can be used to construct compound pathsin which the economy switches between production patterns over time. We show that in an open economy model with VIPIRs, there will exist compound paths that reach the steady in finite time. We also establish conditions for the existence of cyclical equilibria that alternate forever between specialization in the consumption and specialization in the investment good. Consideration of the compound paths can expand the range of parameter values for which the economy has a multiplicity of equilibrium paths and can generate paths to the steady in examples where the steady state is locally unstable.