Consumption Externalities, Production Externalities and Indeterminacy

In this paper we show that consumption externalities reduce the degree of increasing returns needed to generate indeterminacy in a two‐sector optimal growth model. In equilibrium, consumption externalities operate as if the utility function is (close to) linear. If these externalities are strong, the minimum necessary increasing returns approach zero. Therefore, this paper—in a stylized fashion—provides an example of how microbehavior, i.e. interactions at the household level, can generate aggregate instability. Consumption externalities also help to eliminate the counterfactual cyclical behavior of consumption in the two‐sector model.