Welfare Implications of Sunspot Fluctuations

Abstract

The usual conclusion in the literature is that sunspots reduce welfare because of the agents' risk aversion. However, if sunspots can lead to escape from an inferior steady state (poverty trap), this conclusion does not necessarily hold. Escaping trajectories can have much higher welfare than those remaining in the poverty trap. The ex-post welfare effect can be positive for initial conditions such that the probability of escape is sufficiently close to one. Numerical simulations of the model support this conjecture. The distance from the poverty trap boundary to the initial condition point is of critical importance where the escape is concerned. I consider a model in which government has an influence on the exact location of the boundary. Implementing a policy that moves the boundary to the initial condition point greatly increases both the probability of escape and the expected welfare gain.