47 Pages Posted: 17 Mar 2011 Last revised: 16 Sep 2012
Date Written: March 30, 2012
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: 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