Wage Rigidity: A Quantitative Solution to Several Asset Pricing Puzzles

Abstract

In standard production models wage volatility is far too high and equity volatility is far too low. A simple modification - sticky wages due to infrequent resetting together with a CES production function - leads to both (i) smoother wages and (ii) higher equity volatility. Furthermore, the model produces several other hard to explain features of financial data: (iii) high Sharpe ratios, (iv) low and smooth interest rates, (v) time-varying equity volatility and premium, (vi) a value premium, and (vii) a downward-sloping equity term structure. Pro-cyclical, volatile wages are a hedge for firms in standard models, smoother wages act like operating leverage, making profits and dividends more risky.

Keywords: Wage Rigidity, Equity Volatility, Equity Premium, General Equilibrium, Production-Based Asset Pricing, Value Premium

JEL Classification: E21, E23, E32, E44, G12