Charles A. Dice Center Working Paper No. 2012-1
60 Pages Posted: 4 Jan 2012 Last revised: 13 May 2014
Date Written: October 1, 2013
Frictions in the labor market are important for understanding 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 realistic equity premium and stock market volatility, as well as a low and stable interest rate. The equity premium is countercyclical, and forecastable with labor market tightness, a pattern we confirm in the data. Intriguingly, three key ingredients (small profits, large job flows, and matching frictions) in the model combine to give rise endogenously to rare disasters a la Rietz (1988) and Barro (2006).
Keywords: Search frictions, equity premium puzzle, rare disasters, time-varying risk premiums, dynamic stochastic general equilibrium, unemployment, labor market tightness
JEL Classification: E21, E24, E40, G12
Suggested Citation: Suggested Citation
Petrosky-Nadeau, Nicolas and Zhang, Lu and Kuehn, Lars-Alexander, Endogenous Disasters and Asset Prices (October 1, 2013). Charles A. Dice Center Working Paper No. 2012-1; Fisher College of Business Working Paper No. 2012-03-001. Available at SSRN: https://ssrn.com/abstract=1979625 or http://dx.doi.org/10.2139/ssrn.1979625