Growth expectations and asset prices in production economies and labor market matching models

Kaltenbrunner, Georg (2007) Growth expectations and asset prices in production economies and labor market matching models. Doctoral thesis, University of London: London Business School.

Abstract

This thesis improves the standard production economy model (standard stochastic growth (RBC) model) along several important dimensions. In the first part of the thesis we incorporate versions of the labor market matching framework into standard production economy models and show that the so extended model can alleviate two important shortcomings. Firstly, it is a known problem that news about future productivity growth cause a contraction in most standard business cycle models, which is counterfactual. We show that a standard business cycle model that incorporates a search and matching model of the labor market can generate an expansion. Secondly, it has been shown that jointly explaining fluctuations in macroeconomic time series, in particular aggregate employment, and asset prices is difficult. The reason is that households, once allowed to, use their labor-leisure decision to engineer counterfactually smooth consumption profiles, resulting in a counterfactually negative correlation of consumption with employment, and low equity risk premiums. We show that a version of our extended model (combined with habit preferences and capital adjustment costs) where both consumption and labor are endogenous can explain the behavior of asset prices as well as key macroeconomic time series, including aggregate employment. The standard production economy model without habit preferences has been found to fail markedly at explaining asset prices. In the second part of the thesis we show that by two simple adjustments, we disentangle the coefficient of relative risk aversion from the elasticity of intertemporal substitution and we carefully engineer and calibrate the process for wages and consequentially for dividends, the standard model without habit preferences can actually be enabled to explain asset prices to a remarkable extent. This is important, because in many models that assume habit preferences, in particular in production economy models where simple internal habits are assumed, the risk-free rate is far too volatile, and higher risk premiums are in a sense generated through a too volatile stochastic discount factor.