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Economics Letters 63 (1999) 6775

Sunpsots and cycles reconsidered 1


a, b
Subir Chattopadhyay *, Thomas J. Muench
a

Departamento Fundamentos del Analisis
Economico, Universidad de Alicante, E-03071 Alicante, Spain
b
SUNY Stony Brook, Stony Brook, NY, USA
Received 10 April 1998; accepted 4 January 1999

Abstract

We develop a sufficient condition for the existence of stationary sunspot equilibria in a one good OLG economy. This
condition is of a global nature (unlike the usual local indeterminacy condition) and lets us prove existence even for
independent sunspot processes. We use this result to show that the assumption that second period consumption is a normal
good is essential to obtaining two of the results in Azariadis and Guesnerie [Azariadis and Guesnerie, 1986. Rev Economic
Studies 53, 725737], namely, that (a) whenever sunspot equilibria with two states of nature exist, cycles of period two also
exist, and that (b) for a given economy, the set of matrices generating two state stationary sunspot equilibria is a connected
set. 1999 Elsevier Science S.A. All rights reserved.

Keywords: OLG; Cycles; Sunspots; Normal goods

JEL classification: D52; D84

1. Introduction

Since the seminal work of Cass and Shell (1983), much has been learned about the existence and
properties of sunspot equilibria (rational expectations equilibria in which uncertainty matters even
though it does not affect the preferences or endowments of any of the agents)2 . In the case of simple,
one good, representative agent, overlapping generations (OLG) economies, we know from Azariadis
(1981) and Spear (1984) that the indeterminacy of a steady state is sufficient to guarantee the
existence of stationary sunspot equilibria (henceforth, SSE); further, Grandmont (1985) shows that
cycles of period two exist when the monetary steady state is indeterminate. Now, using a continuity
argument, we directly have the result that whenever cycles exist, SSE also exist. The converse
question was asked in Azariadis and Guesnerie (1986) (henceforth, AG), where it was shown that if
consumption when old is a normal good then the existence of a two-state SSE implies the existence of

*Corresponding author. Tel.: 134-96-590-3563; fax: 134-96-590-3685.


E-mail address: subir@merlin.fae.ua.es (S. Chattopadhyay)
1
This paper is a revised version of Hebrew University Working Paper No. 282 (November 1993).
2
See the surveys by Chiappori and Guesnerie (1991) and Guesnerie and Woodford (1992).

0165-1765 / 99 / $ see front matter 1999 Elsevier Science S.A. All rights reserved.
PII: S0165-1765( 99 )00009-9
68 S. Chattopadhyay, T. J. Muench / Economics Letters 63 (1999) 67 75

a two-period cycle. This is a very strong result and does not obtain with more than two states or with
more than one good in each period 3 .
In this paper we confine our attention to exactly the same framework as in AG except for the
condition of normality. We provide a new sufficient condition, which is of a global nature, for the
existence of SSE; the allocations so obtained are seen to display fluctuations of large amplitude.
Furthermore, the result lets us prove existence of SSE for independent sunspot processes.
We use this new existence result to give an example to show that the condition of normality is
essential to the result two state SSE if and only if two period cycles obtained in AG (their Theorem
4). Finally, we show that, given an economy, the set of transition matrices for which two state SSE
exist need not be connected showing that the normality assumption is essential to Theorem 49 in AG.
Each of the results that we obtain is dependent on violating the requirement of normality and this
requires us to reflect upon how reasonable an assumption this might be in a highly aggregated model 4 .
Though the issue is essentially empirical, here is a theoretical justification: with the normality
assumption, the one good model implies a very specific geometric structure which leads to the AG
result; our result shows how this geometric configuration can be broken indicating why the AG result
does not obtain in a multi-good environment, even with preferences which lead to demand functions
which do satisfy the requirement of normality. Also, in most of the literature in this area, preferences
are assumed to be representable by an additively separable utility function, a fact which implies
normality; so it is not surprising that these (new) results have not been noted before.
The rest of this paper is organized as follows: the model is presented in Section 2; the notions of
perfect foresight equilibrium and SSE are defined in Sections 3 and 4, respectively, and Section 5
contains our results. We note that we make heavy use of two fundamental results in AG (their Lemma
1 and Lemma 3).

2. The model

Consider a simple OLG economy. Time is discrete, t 5 0,1,2, . . . , and there is one good in each
period. At each t $ 1, one agent is born and lives for that and the next period. Agents are assumed to
be identical across generations. Denote the consumption vector of the agent of generation t by
( y t , z t )5 . The preferences of every agent will be assumed to be representable by a von Neumann
2
Morgenstern utility function U [y t , z t ] defined on the consumption set R 1 . The function is assumed to
be twice continuously differentiable, differentiably strictly concave and differentiably strictly
monotone on R 211 , with the further property that the closure of every indifference hypersurface which
2 2 y o
passes through R 11 is contained in R 11 . Endowments will be denoted by (v , v ). We assume that

3
Woodford (1986) shows that, even within the one good framework, the AG result does not hold if the government buys the
good or preferences fail to satisfy a boundary condition.
4
On theoretical grounds, when there is no risk, we can use the Excess Demand Function Theorem to argue that an offer
curve displaying non-normal goods is actually the sum of the demand functions of two perfectly well-behaved individuals.
This continues to be the case for small, or purely local, risks as in Guesnerie (1986). Since our constructions will not be of a
purely local nature, we do not invoke this argument.
5
Notation used: for deterministic variables, subscripts will indicate the generation that we are referring to, while, in the case
of prices, they identify the period.
S. Chattopadhyay, T. J. Muench / Economics Letters 63 (1999) 67 75 69

(v y , v o) [ R 211 . These assumptions will guarantee the existence of well-defined smooth demand
functions which stay away from the boundary of the consumption set. The agent born at t 5 0 lives
only when she is old. She has a monotone increasing utility function u(z 0 ), zero second period
endowment of the good, and one unit of fiat money. We further assume that U1 [v y , v o ] /
U2 [v y , v o ] , 1, so that we are in the Samuelson case.

3. Perfect foresight

Under perfect foresight, where all the future prices are known with certainty, the consumers
behaviour can be summarized using the savings function, M:R 11 [0, v y ], defined as:
y o
M( pt /pt 11 ): 5argmax U [v 2 m, v 1 m pt /pt 11 ].
0#m # v y

As the price ratio is varied, this function generates a locus of points in the space of net trades called
the offer curve.
A perfect foresight equilibrium for this economy is a sequence of prices h pt j t $1 such that
M( pt /pt 11 ) 5 1 /pt for all t $ 1. The monetary steady state, or the Golden Rule allocation, corresponds
to the consumption vector (v y 2 m*, v o 1 m*) where m*: 5 M(1). Also, a periodic allocation of
period two corresponds to a pair of prices, p1 and p2 , such that M( p1 /p2 ) 5 1 /p1 and M( p2 /p1 ) 5 1 /
p2 .

4. Stationary sunspots

Consider a time homogeneous Markov process with two states, s [ ha, b j.

P5 Sp1 2 p
aa

bb
1 2 p aa
p bb
D
is the transition matrix where p ss9 is the probability of being in state s9 in the next period conditional
on being in state s in the current period. The process describes the evolution of an extrinsic state, i.e.
preferences and endowments continue to be deterministic. But agents believe that this random variable
affects prices. We consider equilibria in which prices depend on only the current realization of the
extrinsic state. An SSE is a pair of prices and associated allocations such that agents beliefs about
prices are fulfilled and their optimizing demands, when these (state dependent) prices are used, clear
markets.
Given the current state, s, the representative agents behaviour can be summarized by a function
M s :R 11 3 [0, 1] [0, v y ], for s 5 a, b, defined as 6 :

M s ( p s /p s 9 , p ss ): 5argmax p ssU [v y 2 m s , v o 1 m s ]
0#m s # v y

1 (1 2 p )ssU [v y 2 m s , v o 1 m s p s /p s 9 ], s9 s.
6
When we restrict our attention to stationary stochastic variables, as in this section, superscripts will represent the state.
70 S. Chattopadhyay, T. J. Muench / Economics Letters 63 (1999) 67 75

As AG show, this function is a simple deformation of the savings function under certainty. The
following important lemma is due to them.

Lemma 1AG. The function M s ( p s /p s9 , p ss ) is continuous and such that M s ( p s /p s9 , 0) 5 M( p s /p s 9 )


for all p s /p s9 , and M s (1, p ss ) 5 M(1) for all p ss . Furthermore, M s ( p s /p s9 , p ss ) lies between
s s9 s s9 ss s s s9 ss s s s9
M( p /p ) and M(1) for all p /p and p ; also, M ( p /p , p ) lies between M ( p /p , 0) and
s s s9 ss ss ss
M ( p /p , p ) for all p , p .

Like the savings function under certainty, this function also generates a locus of points in the space
of net trades giving the net trade in the current state (when young) and that in the complementary state
when old. This locus will be called the state s stochastic offer curve.

Definition 1. Given preferences and initial endowments the pair ( p a , p b ) will constitute a stationary
sunspot equilibrium (SSE) for P if:

the demands expressed by the agents at those prices clear the markets so that

M a ( p a /p b , p aa ) 5 1 /p a , M b ( p b /p a , p bb ) 5 1 /p b ;

p a p b and;
P S D
0 1
1 0
.

The second and third restriction in Definition 1 rule out the Golden Rule and cycles of period two
from being labeled as SSE.
Fig. 1 illustrates the concepts developed so far in the space of net trades 7 : the two solid lines are the
offer curve and the state a stochastic offer curve. Given a relative price p a /p b , a budget line is
determined. The point at which the budget line intersects the offer curve is labeled 1 and has
coordinates (2M a ( p a /p b , 0),( p a /p b )M a ( p a /p b , 0)), representing the planned savings of the agent
and the planned excess consumption when old. Similarly, for the state a stochastic offer curve, the
point of intersection, labeled 2, is (2M a ( p a /p b , p aa ),( p a /p b )M a ( p a /p b , p aa )), representing the
planned savings of the agent born in state a and the planned excess consumption when old if the state
turns out to be b (the planned excess consumption when old if the state turns out to be a is given by
M a ( p a /p b , p aa )).

5. Results

Consider the following function defined in AG (Spear (1984) has a similar construction) where
w: 5 p a /p b and F:R 11 3 [0, 1] 3 [0, 1] R

7
By applying the results in Cass et al. (1979) on constructing offer curves, one can show that there exist well behaved
preferences which generate the offer curve in Fig. 1.
S. Chattopadhyay, T. J. Muench / Economics Letters 63 (1999) 67 75 71

F(w; p aa , p bb ): 5 wM a (w, p aa ) 2 M b (1 /w, p bb ).

It is easy to see that, given a transition matrix, P, an SSE exists if and only if F( ? ; p aa , p bb ) has a
positive root other than 1; for p aa 5 p bb 5 0 we get a two-period cycle.
We can visualize this function in the space of net trades as follows: pick a value for the relative
price w, i.e. for p a /p b , wM a (w, p aa ) is the second coordinate of the point at which the state a
stochastic offer curve and the budget line for the relative price w intersect; M b (1 /w, p bb ) is the
second coordinate of the point of intersection of the reflection around the diagonal of the state b
stochastic offer curve and the budget line for w (which is, evidently, the first coordinate of the point of
intersection between the state b stochastic offer curve and the budget line for the relative price
p b /p a 5 1 /w). uF(w; p aa , p bb )u is given by the difference between the value of these two second
coordinates. Fig. 2 illustrates this by superimposing the reflected state b stochastic offer curve on the
state a stochastic offer curve.
Clearly, the SSE of this economy correspond to the intersections (other than the trivial ones) of the
two curves in Fig. 2, since these are the positive roots, other than 1, of the function F( ? ; p aa , p bb );
the non-trivial intersections of the two curves when p aa 5 p bb 5 0 give us two period cycles.
Now consider an economy with an indeterminate monetary steady state, so that the slope of the
offer curve at the Golden Rule is less than 1 in absolute value, and look at the two stochastic offer
curves when p aa 5 p bb 5 0. Evidently, the curves have a non-trivial intersection and we obtain a
two-period cycle. Also, from Lemma 1AG, for p aa and p bb sufficiently small but positive, by

Fig. 1.
72 S. Chattopadhyay, T. J. Muench / Economics Letters 63 (1999) 67 75

Fig. 2.

continuity, we will continue to have intersections. This is a geometric proof of the fact that the
indeterminacy of the monetary steady state is a sufficient condition for the existence of (i) two-period
cycles (a result obtained by Grandmont (1985)) and (ii) SSE (a result obtained by Azariadis (1981),
Spear (1984), AG, etc.)8 .
We need another important result due to AG which we now state.

Lemma 2AG. The function F is continuous. For each (p aa , p bb ) it has the following properties:

(i) F(1; p aa , p bb ) 5 0;
(ii) F ` as w `;
(iii) For w small enough, F(w; p aa , p bb ) , 0;
(iv) If w is a root of F(w; p aa , p bb ), then 1 /w is a root of F(w; p bb , p aa ).

Result (i) simply says that the Golden Rule corresponds to a root of F, (ii) and (iii) give the
boundary properties of the function, while (iv) captures an important symmetry that the function
exhibits.

8
The condition indeterminacy implies SSE exist does not depend on normality. If, the offer curve has a negative slope and
bends backwards, both at the Golden Rule, then we must have indeterminacy and SSE will exist; in particular, they exist for
matrices with p aa 5 p ba , i.e. independent processes. However, that sort of offer curve can be ruled out by assuming that
demand when old is a normal good, say by postulating additive separability of the utility function, and then we have the
result that SSE do not exist, at least not locally around the steady state, for any independent process (see Azariadis, 1981).
S. Chattopadhyay, T. J. Muench / Economics Letters 63 (1999) 67 75 73

We are now in a position to prove our results.

Theorem 1. Consider an economy with the property that for some pair of prices, p and p , where
p . p , ( p /p ) ? M( p /p ) , M(1). There are transition matrices, P, such that, for these matrices, such
an economy has SSE 9 .

Proof. Consider a matrix with p aa 5 0 and p bb 5 1. Clearly, M b ( p b /p a ,1) 5 M(1) 5 m* for all
positive price ratios. So, the reflected state b stochastic offer curve is a horizontal line with a
discontinuity on the right. Also, by the condition in the Theorem, and Lemma 1AG, ( p a /p b ) ? M a ( p a /
p b , 0) , M(1) 5 m* for some pair of prices for which p a . p b , so that, F( p a /p b ; 0, 1) , 0 for this
pair of prices. But then F( ? ; 0, 1) must have a positive root by (i) and (ii) of Lemma 2AG. Now, by
continuity of F in the probabilities, SSE exist for transition matrices with p aa 5 e . 0, and
p bb 5 1 2 e , e . 0. h
aa ba
In the last step of the proof, we can set e 5 e . 0 in order to obtain p 5 p 5 e . 0; so the
Theorem provides conditions under which SSE must exist for some independent processes.
Furthermore, the condition given in the Theorem requires the offer curve to dip down and cannot be
satisfied if second period consumption is a normal good. Finally, we can rule out cycles of period two
by imposing the additional condition that F( ? ; 0, 0) has a unique positive root; this does not interfere
with the proof of the Theorem.
Fig. 1 provides an example. As indicated in the figure, the offer curve drawn satisfies the sufficient
condition given in the Theorem 10 ; therefore, the underlying economy must have SSE. But for the offer
curve in Fig. 1 there do not exist cycles of period two (an easy way to see this is to use the geometric
proof of existence given earlier, i.e. superimpose the reflection of the offer curve on the offer curve
itself and observe that the curves obtained only have trivial intersections).

Proposition 1. There are robust examples of economies which possess SSE but do not have equilibria
which are cycles of period two.

Inspection of the proof of the Theorem shows that it actually demonstrates that SSE exist for
matrices near the matrix with p aa 5 0, p bb 5 1. By the symmetry condition in Lemma 2AG (iv),
SSE exist also for matrices near the matrix with p aa 5 1, p bb 5 0. Also, by invoking Proposition 1,
the economy need not have a two-period cycle so that 1 could be the only root of F( ? ; 0, 0). Hence,
the set of matrices for which SSE exist need not be connected.

Proposition 2. There are robust examples of economies for which the set of matrices generating SSE
is not a connected set.

In Fig. 3 we indicate the set of matrices for which SSE exist for the offer curve in Fig. 1; the set of
interest is marked as a shaded region. As p aa varies, SSE begin to appear provided that p bb [

9
The result also holds if instead we assume that for some pair of prices, p and p, where p , p,
( p /p ) ? M( p /p ) . M(1).
10
The offer curve can be redrawn so that it continues to satisfy the condition even if it has a negative slope at the Golden
Rule and the Golden Rule is a determinate steady state; this requires that the offer curve bend backwards at some point other
than the Golden Rule.
74 S. Chattopadhyay, T. J. Muench / Economics Letters 63 (1999) 67 75

Fig. 3.

[ f(p aa ), 1] for some function f :[0, 1] [0, 1], f(0) . 0, since no two-period cycle exists, and as p aa
increases SSE begin to appear for higher values of p bb so that the function f is increasing; however,
beyond a certain value of p aa , SSE fail to exist. Roughly speaking, the failure of existence occurs at
the point at which the state a stochastic offer curve no longer dips down sufficiently so that it does
not cross the horizontal line through the Golden Rule. By property (iv) in Lemma 2AG, the set of
matrices for which SSE exist is symmetric with respect to the diagonal in the unit square. The figure
is schematic in that the boundary of the shaded set is shown to be linear even though, typically, it will
not be linear.

Acknowledgements

We thank a referee for useful comments. Chattopadhyay gratefully acknowledges financial support
in the form of a Lady Davis Fellowship at the Hebrew University, and additional support from the
IVIE and DGICyT via grant number PB94-1504.

References

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Cass, D., Okuno, M., Zilcha, I., 1979. The role of money in supporting the Pareto optimality of competitive equilibrium in consumption
loan type models. Journal of Economic Theory 20, 4180.
Cass, D., Shell, K., 1983. Do sunspots matter? Journal of Political Economy 91, 189227.
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Chiappori, P.A., Guesnerie, R., 1991. Sunspot equilibria in sequential markets models. In: Hildenbrand, W., Sonnenschein, H. (Eds.),
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