Instabilities in large economies: aggregate volatility without idiosyncratic shocks

TL;DR

This paper presents a dynamical model of interconnected firms showing that market imperfections and frictions can lead to endogenous crises and aggregate volatility, even without idiosyncratic shocks, due to instability and chaotic dynamics.

Contribution

It demonstrates that market frictions can cause endogenous economic fluctuations and crises, challenging traditional views that rely on external shocks.

Findings

Aggregate volatility persists without idiosyncratic shocks

Instability leads to chaotic, turbulent economic dynamics

Endogenous crises emerge from market frictions and agent behavior

Abstract

We study a dynamical model of interconnected firms which allows for certain market imperfections and frictions, restricted here to be myopic price forecasts and slow adjustment of production. Whereas the standard rational equilibrium is still formally a stationary solution of the dynamics, we show that this equilibrium becomes linearly unstable in a whole region of parameter space. When agents attempt to reach the optimal production target too quickly, coordination breaks down and the dynamics becomes chaotic. In the unstable, "turbulent" phase, the aggregate volatility of the total output remains substantial even when the amplitude of idiosyncratic shocks goes to zero or when the size of the economy becomes large. In other words, crises become endogenous. This suggests an interesting resolution of the "small shocks, large business cycles" puzzle.