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Wage Rigidity: A Solution to Several Asset Pricing Puzzles

Author

Listed:
  • Jack Favilukis

    (London School of Economics)

  • Xiaoji Lin

    (The Ohio State University)

Abstract
In standard production based models labor income volatility is far too high and equity return volatility is far too low (excess volatility puzzle). We show that a simple modification of the standard model - infrequent renegotiation of labor income - allows the model to match both the smoother wages and the high equity return volatility observed in the data. Furthermore, the model produces several other hard to explain features of financial data: high unconditional Sharpe Ratios; time-varying equity premium, equity volatility, and Sharpe Ratio; as well a higher expected returns for value stocks over growth stocks. The intuition is that in standard models, highly pro-cyclical and volatile wages act as a hedge for the firm, reducing profits in good times and increasing them in bad times; this causes profit and returns to be too smooth. Infrequent renegotiation smoothes wages and smooth 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. Consistent with our model, we show that in the data wage growth can forecast long horizon returns, furthermore we find the same predictability at the industry level, with more rigid industries having stronger predictability.

Suggested Citation

  • Jack Favilukis & Xiaoji Lin, 2012. "Wage Rigidity: A Solution to Several Asset Pricing Puzzles," 2012 Meeting Papers 589, Society for Economic Dynamics.
    • Handle: RePEc:red:sed012:589
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    References listed on IDEAS

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    Cited by:

    1. Kuehn Lars-Alexander & Petrosky-Nadeau Nicolas & Zhang Lu, "undated". "An Equilibrium Asset Pricing Model with Labor Market Search," GSIA Working Papers 2010-E63, Carnegie Mellon University, Tepper School of Business.
    2. Frederico Belo & Jun Li & Xiaoji Lin & Xiaofei Zhao, 2017. "Labor-Force Heterogeneity and Asset Prices: The Importance of Skilled Labor," The Review of Financial Studies, Society for Financial Studies, vol. 30(10), pages 3669-3709.
    3. Frederico Belo & Xiaoji Lin & Fan Yang, 2019. "External Equity Financing Shocks, Financial Flows, and Asset Prices," The Review of Financial Studies, Society for Financial Studies, vol. 32(9), pages 3500-3543.
    4. Gian Luca Clementi & Berardino Palazzo, 2019. "Investment and the Cross‐Section of Equity Returns," Journal of Finance, American Finance Association, vol. 74(1), pages 281-321, February.
    5. Ryo Jinnai, 2015. "Innovation, Product Cycle, and Asset Prices," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 18(3), pages 484-504, July.
    6. Mikhail Simutin & JessieJiaxu Wang & Lars Kuehn, 2014. "A Labor Capital Asset Pricing Model," 2014 Meeting Papers 695, Society for Economic Dynamics.
    7. Robert E. Hall, 2017. "High Discounts and High Unemployment," American Economic Review, American Economic Association, vol. 107(2), pages 305-330, February.

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    More about this item

    JEL classification:

    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • E23 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Production
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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