An incomplete markets model of business cycles

This paper explores the effects of incomplete markets and positive spillovers on aggregate and industry output behavior. We consider an economy composed of a fixed set of infinitely-lived industries. When industries coordinate production decisions they jointly improve their productivity. Markets are missing, however, in the sense that industries cannot automatically form the most productive coalitions due to the presence of communication frictions. The degree of coordination between industries is determined by a random matching process from which complex coalitions of industries emerge through bilateral industry interactions. High production by an industry improves the probability with which it communicates with other industries, creating a positive spillover effect on the productivity of the rest of the economy. Aggregate output behavior exhibits both persistent fluctuations as well as procyclical productivity.