Description

We provide a complete analysis of previously undocumented sunspot equilibria in a canonical dynamic economy with imperfect risk sharing. Methodologically, we employ stochastic stability theory to establish existence of this broad class of sunspot equilibria. Economically, self-fulfilling fluctuations are characterized by uncertainty shocks: changing beliefs about volatility trigger asset trades, which impacts productive efficiency and justifies the degree of uncertainty. We show how rational sentiment helps resolve two puzzles in the macro-finance literature: (i) financial crises emerge suddenly, featuring (quantitatively) hard-to-explain volatility spikes and asset-price declines; (ii) asset-price booms, with below-average risk premia, predict busts and financial crises.