Endogenous Economic Disasters and Asset Prices

Lu Zhang (), Lars-Alexander Kuehn and Nicolas Petrosky-Nadeau
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Lars-Alexander Kuehn: Carnegie Mellon University

No 163, 2014 Meeting Papers from Society for Economic Dynamics

Abstract: 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).

Date: 2014
New Economics Papers: this item is included in nep-dge
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