Multiple Expectational Equilibria under Monopolistic Competition

This paper shows that a monopolistically competitive economy with real investment can have multiple rational expectations equilibria: one is associated with entrepreneurs' optimistic expectations about future demand; another with entrepreneurs' pessimism. It also shows that an optimistic expectational equilibrium Pareto dominates a pessimistic equilibrium. An investment subsidy can be beneficial both by reducing the original underinvestment distortion and by changing firms' expectations from pessimistic to optimistic. The most important assumption is increasing returns to scale, and monopolistic competition makes increasing returns consistent with each producer's optimization.