An Equilibrium Asset Pricing Model with Labor Market Search
Search frictions in the labor market help explain the equity premium in the financial market. We embed the Diamond-Mortensen-Pissarides search framework into a dynamic stochastic general equilibrium model with recursive preferences. The model produces a sizeable equity premium of 4.54% per annum with a low interest rate volatility of 1.34%. The equity premium is strongly countercyclical, and forecastable with labor market tightness, a pattern we confirm in the data. Intriguingly, search frictions, combined with a small labor surplus and large job destruction flows, give rise endogenously to rare disaster risks a la Rietz (1988) and Barro (2006).
For helpful comments, we thank Ravi Bansal, Michele Boldrin, Andrew Chen, Jack Favilukis, Nicolae Garleanu, Xiaoji Lin, Laura Xiaolei Liu, Stavros Panageas, Amir Yaron, and other seminar participants at the Federal Reserve Bank of New York, the 2010 Society of Economic Dynamics meeting, the 2010 CEPR European Summer Symposium on Financial Markets, the 2010 Human Capital and Finance Conference at Vanderbilt University, the 2011 American Finance Association Annual Meetings, and the 2nd Tepper/LAEF Advances in Macro-Finance Conference at Carnegie Mellon University. All remaining errors are our own. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.