Wage Rigidity: A Solution to Several Asset Pricing Puzzles

47 Pages Posted: 17 Mar 2011 Last revised: 16 Sep 2012

Jack Y Favilukis

University of British Columbia (UBC) - Division of Finance

Xiaoji Lin

Ohio State University (OSU) - Fisher College of Business

Date Written: March 30, 2012

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.

Keywords: Equity Volatility, Equity Premium, Return Predictability, Wage Rigidity, Long Run Risk, General Equilibrium

JEL Classification: E22, E23, E24, E32, G12

Suggested Citation

Favilukis, Jack Y and Lin, Xiaoji, Wage Rigidity: A Solution to Several Asset Pricing Puzzles (March 30, 2012). Available at SSRN: https://ssrn.com/abstract=1786838 or http://dx.doi.org/10.2139/ssrn.1786838

Jack Y Favilukis (Contact Author)

University of British Columbia (UBC) - Division of Finance ( email )

2053 Main Mall
Vancouver, BC V6T 1Z2
Canada

Xiaoji Lin

Ohio State University (OSU) - Fisher College of Business ( email )

2100 Neil Avenue
Columbus, OH 43210-1144
United States

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