Liquidity Constraints, Heterogeneous Households and Sunspots Fluctuations

Abstract : This paper is concerned with the empirical relevance of indeterminacy and sunspots in explaining the business cycle. It argues that financial constraints provide a propagation mechanism able to generate business cycle facts observed in data in response to sunspot shocks. This point is demonstrated using an equilibrium business cycle model featuring heterogeneous households, endogenous labor supply and liquidity constraints. We first show that the model exhibits indeterminacy for roughly constant returns to scale. We then establish that our model accounts for stylized facts that neither the standard RBC model nor previous sunspots models have been able to capture. More specifically, the model driven purely by sunspots matches the procyclical movements in aggregate consumption, and the positively correlated forecastable changes of basic macroeconomic variables.