Sunspot Equilibrium

Sunspot Equilibrium

In sunspot equilibrium, the allocation of resources depends on some purely extrinsic random variable – a random variable that has no effect on the fundamentals. The SE concept provides a basis for rational-expectations models of excess market volatility. The best way to analyze bank runs and related financial fragilities is as a sunspot equilibrium outcome in the pre-deposit game. The current financial meltdown is largely financial and partly sunspot driven. Sunspots can improve resource allocation in non-convex and incentive-constratined economies.

Any one of the following departures from the basic Walrasian model allows there to be proper sunspot equilibria:

  • The “double infinity” of consumers and dated commodities (as naturally arise in infinite-horizon OG models). See Shell JPE (1971), Shell (1977) and Cass and Shell (1989).
  • Restrictions on market participation (as naturally arise in OG models). See Shell (1977) and Cass and Shell (1983).
  • Incomplete markets (as naturally arise in OG models and elsewhere). See Shell (1977) and the work of David Cass and others.
  • Asymmetric information. See Peck and Shell (1985, 1991) and Aumann, Peck and Shell (1988). See also mechanism design problems such as Peck and Shell (2003, 2010).
  • Imperfect competition (as modeled, e.g. by market games). See Peck and Shell (1985, 1991).
  • Consumption or production externalities, as introduced by Steve Spear and successfully explored in applied work on economic fluctuations by Jess Benhabib, Roger Farmer, Stephanie Schmitt-Grohé, Yi Wen, Pengfei Wang, and others.
  • Nonconvexities in consumption or production. See Shell and Wright (1993) Goenka and Shell (1997), and Garratt, Keister, Qin, and Shell (2002), and Garratt, Keister, and Shell (2004).
  • Monetary indeterminacy. See Bhattacharya, Guzman and Shell (1998) for a very simple model that elucidates “the fundamental source of sunspot equilibria”.


Sunspot Pictures