Favilukis, Jack and Lin, Xiaoji (2012) Wage rigidity: a solution to several asset pricing puzzles. . (Unpublished)
This paper studies asset prices in a general equilibrium model with staggered wage contracts. We show that infrequent renegotiation of labor wages is crucial for production-based models to explain the high equity return volatility (excess volatility puzzle) observed in the data. Our preferred model combining wage rigidity with long run productivity risk can produce several hard to explain features of both financial and business cycle data: i) high unconditional equity premium and equity volatility; ii) countercyclical variation in the equity premium, in its volatility, and in Sharpe Ratio; iii) long-horizon predictability of returns with high R² values; iv) a higher expected returns for value stocks over growth stocks; and v) smooth wages and volatile aggregate profits. The intuition is that in standard models, highly pro-cyclical and volatile wages act as a hedge for the firm, reducing profits in good times and increasing them in bad times; this causes profit and returns to be too smooth. Infrequent renegotiation smoothes wages and smooth wages act like operating leverage, making profits more risky. Bad times and value firms are especially risky because committed wage payments are high relative to output. Consistent with our model, we show that in the data wage growth can forecast long horizon returns; furthermore we find the same predictability at the industry level, with more rigid industries having stronger predictability; lastly we show that growth stocks have lower degree of wage rigidity than value stocks in the data.
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