An Equilibrium Asset Pricing Model with Labor Market Search

January 27, 2012

By Lars-Alexander Kuehn, Nicolas Petrosky-Nadeau and Lu Zhang

Search frictions in the labor market help explain 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 a sizeable equity premium of 4.54% per annum with a low interest rate volatility of 1.34%. The equity premium is strongly countercyclical, and forecastable with labor market tightness, a pattern we confirm in the data. Intriguingly, search frictions, combined with a small labor surplus and large job destruction flows, give rise endogenously to rare disaster risks à la Rietz (1988) and Barro (2006).

What else can the labor search model explain? Here it solves the equity premium puzzle and rare disaster risk. These are exciting results. But skimming through the paper (I do not want to delay mailing the NEP-DGE report further) I could not find good intuition for this except for the following: with the search frictions, wages are less volatile than the marginal productivitry of labor, because of the outside option of unemployment in the Nash bargaining of the wage. That makes profits more volatile than output, and you have an equity premium. But it seems to me that it is the Nash bargaining that drives the result, not the search mechanism. Have a different wage determination, and the result may not hold. Correct me if I am wrong.


Directed Search over the Life Cycle

January 20, 2012

By Guido Menzio, Irina A. Telyukova and Ludo Visschers

We develop a life-cycle model of the labor market in which different worker-firm matches have different quality and the assignment of the right workers to the right firms is time consuming because of search and learning frictions. The rate at which workers move between unemployment, employment and across different firms is endogenous because search is directed and, hence, workers can choose whether to seek low-wage jobs that are easy to find or high-wage jobs that are hard to find. We calibrate our theory using data on labor market transitions aggregated across workers of different ages. We validate our theory by showing that it correctly predicts the pattern of labor market transitions for workers of different ages. Finally, we use our theory to decompose the age profiles of transition rates, wages and productivity into the effects of age variation in work-life expectancy, human capital and match quality.

This paper is a good example of the progress labor search theory is making in capturing the complex realities of the job market. The life cycle element here is a major addition, and models like this will be useful to understand the impact of labor market policies on different age cohorts.

Wealth inequality and the optimal level of government debt

January 6, 2012

By Sigrid Röhrs and Christoph Winter

In this paper, we quantitatively analyze to what extent a benevolent government should issue debt in a model where households are subject to idiosyncratic productivity shocks, insurance markets are missing and borrowing is restricted. In this environment, issuing government bonds facilitates saving for self-insurance. Despite this, we find that in a calibrated version of the model that is consistent with the skewed wealth and earnings distribution observable in the U.S., the government should buy private bonds, and not issue public debt in the long run. The reason is that in the U.S., a large fraction of the population has almost no wealth or is even in debt. The wealth-poor, however, do not profit from an increase in the interest rate following an increase in public debt. Instead, they gain from higher wages that result from a reduction in debt. We show that even when the short run costs of higher capital taxation are taken into account, it still pays off to reduce government debt on overall. Moreover, we find that endogenizing household’s borrowing constraints by assuming limited commitment leads to even higher asset levels being optimal in the long run.

One standard justification for government debt is that it allows to complete markets. The best case is in two-period overlapping generation models, but the same case can be made in models without other assets or money. This paper shows that this result could be reversed as government debt increases the interest rate and reduces wages, and the poor rely almost exclusively on wages for income.