What is a Sunspot?
In economics, a sunspot is an economic variable that has no direct impact on economic fundamentals. A sunspot does not necessarily have any intuitively obvious connection to the economy. A variable that is described as a sunspot would be considered an extrinsic random variable in econometric modeling.
- The term sunspots in economics refers to variables that impact economic outcomes but reflect something other than the basic fundamentals of an economy.
- Social and psychological factors such as investor sentiment, expectations, or reactions to non-economic events can be classified as sunspots.
- These variables are called sunspots because in the past some economists believed there was a correlation between actual sunspots and economic performance.
An extrinsic random variable is one that does not affect the theory being modeled directly, though it may have an indirect effect. The opposite of an extrinsic random variable is an intrinsic random variable. An intrinsic random variable is one that has a direct and generally intuitive effect on the theory being studied in an econometric model.
Sunspots in economic models often reflect social or psychological phenomena that influence economic decisions beyond the fundamental factors, such as supply and demand conditions, prices, and consumer preferences. Factors like business optimism, consumer expectations, self-fulfilling prophecies, and the “animal spirits” of investors can all represent sunspots that influence economic outcomes without reflecting any objectively real property of the economy.
As an example, consider a model that attempts to predict U.S. gross domestic product ("GDP"). GDP is determined by many factors, which are used as random variables in the model. Factors that would be expected to affect the GDP of a nation, such as the labor force participation rate, productivity, consumer demand and inflation, would be considered intrinsic random variables. These factors have been shown to directly influence GDP. Factors that do not have a direct connection to GDP would be referred to as extrinsic random variables, or sunspots. For instance, a factor that represents an upcoming political election would be a sunspot.
Although the simple fact that there will be an election has no direct impact on economic fundamentals, the winning party could materially change government policy. Rational people and businesses will form expectations based on the victor's policy when making financial decisions, and those decisions could positively or negatively affect U.S. GDP in the future. While the election itself has no fundamental relationship to GDP, it could have an indirect influence that will eventually affect U.S. GDP, making this factor a sunspot.
Origin of the Term Sunspot
The term "sunspot" is a reference to the work of English economist and logician William Stanley Jevons (1835–1882). Among the more minor of his works was Commercial Crises and Sun-Spots, published Nov. 1878. In this work, he attempted to relate business cycles with actual sunspots. He reasoned that sunspots impact weather, which affect crop production. Changing crop production could, in turn, be expected to cause changes in the overall economy. The connection between solar sunspots and business cycles has ultimately been proven statistically insignificant. However, later economists adopted the term "sunspot" as a less technical way to refer to random variable that can induce variation in an economic model that does not result from any economic fundamentals.