Theoretical Economics Letters

Volume 1, Issue 3 (November 2011)

ISSN Print: 2162-2078   ISSN Online: 2162-2086

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Are Sunspots Stabilizing?

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DOI: 10.4236/tel.2011.13023    6,498 Downloads   10,065 Views   Citations
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ABSTRACT

The reduced form solutions of indeterminate rational expectations models often include extraneous expectational errors or “sunspots”. Sunspots are usually modeled as independent of the model’s fundamentals, and are often presumed to result in excess volatility. An alternate approach, however, is to assume that sunspots include both an overreaction or underreaction to fundamentals, as well as genuine extraneous noise. This paper uses a simple linear model to formally show how the relationship between sunspots and fundamentals affects aggregate volatility. Sunspots reduce volatility if 1) they include an undereaction to fundamentals, 2) the variance of genuine extraneous noise is sufficiently small, and 3) the root that causes indeterminacy is sufficiently far from one.

Cite this paper

P. Shea, "Are Sunspots Stabilizing?," Theoretical Economics Letters, Vol. 1 No. 3, 2011, pp. 111-113. doi: 10.4236/tel.2011.13023.

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