Wage Rigidity: A Solution to Several Asset Pricing Puzzles

Abstract:     
In standard models wages are too volatile and returns too smooth. We make wages sticky through infrequent resetting, resulting in both (i) smoother wages and (ii) volatile returns. Furthermore, the model produces other puzzling features of financial data: (iii) high Sharpe Ratios, (iv) low and smooth interest rates, (v) time-varying equity volatility and premium, and (vi) a value premium. In standard models, highly pro-cyclical and volatile wages are a hedge. The residual profit becomes unrealistically smooth, as do returns. Smoother wages act like operating leverage, making profits more risky. Bad times and unproductive firms are especially risky because committed wage payments are high relative to output.

Number of Pages in PDF File: 47

Keywords: general equilibrium, heterogeneous firms, equity premium, value premium, return volatility, wage rigidities, return predictability

JEL Classification: G12, E13, E22, E23, E32

working papers series