Working Paper: NBER ID: w17742
Authors: Lars Alexander Kuehn; Nicolas Petrosky-Nadeau; Lu Zhang
Abstract: 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).
Keywords: Equity Premium; Labor Market Search; Dynamic Stochastic General Equilibrium
JEL Codes: G12; J23
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| search frictions (F12) | equity premium (G12) |
| labor market tightness (J20) | stock market excess returns (G12) |
| labor market tightness (J20) | job finding rate (J68) |
| job finding rate (J68) | equity premium (G12) |
| equity premium (G12) | countercyclical behavior (E32) |
| search frictions + job destruction rates + labor market conditions (J63) | rare disaster risks (H84) |
| high unemployment rates (J64) | low probabilities of extreme economic downturns (E32) |