Wage Rigidity: A Quantitative Solution to Several Asset Pricing Puzzles

Jack Favilukis and Xiaoji Lin

The Review of Financial Studies, 2016, vol. 29, issue 1, 148-192

Abstract: In standard production models, wage volatility is far too high, and equity volatility is far too low. A simple modification–sticky wages because of infrequent resetting together with a constant elasticity of substitution (CES) production function leads to both smoother wages and higher equity volatility. Further, the model produces several other hard-to-explain features of financial data: high Sharpe ratios, low and smooth interest rates, time-varying equity volatility and premium, a value premium, and a downward-sloping equity term structure. Procyclical, volatile wages are a hedge for firms in standard models; smoother wages act like operating leverage, making profits and dividends riskier. Received July 30, 2013; accepted July 6, 2015 by Editor Geert Bekaert.

Date: 2016
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