DEFINITION of Sunspot

In economics, a sunspot is an economic variable that has no direct impact on economic fundamentals. Economic fundamentals are qualitative and quantitative factors that help explain the health of the economy. Among a long list of others, economic fundamentals include such things as consumer confidence, employment levels and interest rates. A variable that is described as a sunspot would be considered an extrinsic random variable in econometric modeling. 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.

BREAKING DOWN Sunspot

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 consider 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" originated with 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 November 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. Though the connection between solar sunspots and business cycles has ultimately been proven statistically insignificant, the term "sunspot" endured as a less technical way to refer to an extrinsic random variable.