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.