Sunspot: What It is, How It Works, Origin

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, and may in fact have no logical or causal connection at all, just a spurious correlation to some economic variable. A variable that is described as a sunspot would be considered an extrinsic random variable in econometric modeling.  

Understanding Sunspots

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. 

Economists modeling sunspots use them in just this way. An extrinsic random variable may not be a direct factor in any current economic process or relationship, but is influential nonetheless. Often this is because its realization in the future impacts current expectations.

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 November 1878. In this work, he attempted to relate business cycles with actual sunspots. He reasoned that sunspots impact weather, which affects 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 widely been dismissed as statistically insignificant.

However, later economists adopted the term "sunspot" as a less technical way to refer to a random variable that can induce variation in an economic model that does not result from any economic fundamentals. Economists David Cass and Karl Shell used the term to refer to an extrinsic random variable. In their 1983 paper, Kass and Shell, demonstrate how extrinsic random variables can help determine which of several possible states of general equilibrium an economy will reach.

These "sunspots" represent exogenous variables or external shocks that shape the path of the economy not so much through their direct impact but because of the way people change their behavior before they even happen. This use of the term has become far more common among economists since the dismissal of Jevons's theory.