The Real Effects of Inflation Volatility Driven by Sunspots

This paper provides a theoretical approach to investigate the real effects of inflation volatility driven by a self-fulfilling prophecy (i.e., sunspot equilibrium) on investment, capital accumulation, and welfare in a representative-agent macroeconomics model. The model is constructed based on empirical evidence that (1) inflation volatility (rather than inflation rates) negatively affects national investment, (2) uncertainty about inflation is attributed more to market psychology than economic fundamentals, and (3) firms are risk-averse decision makers. We show that the introduction of inflation-indexed bonds can improve welfare. A steady-state analysis quantifies the impact of inflation volatility on investment and welfare