Labor market search, endogenous disasters and the equity premium puzzle

The present paper investigates: (i) the endogenous disaster mechanism in a textbook search-and-matching model when calibrated with a constant flow value of unemployment that is close to average labor productivity and (ii) its contribution to solve the equity premium puzzle. I offer a simple explanation for the core of the disaster mechanism: the lower bound—say Xkink—on the annuitized costs the firm incurs from investing in a match lies sufficiently close to the body of productivity’s distribution. If labor productivity drops close to, or even below Xkink for consecutive periods, the firm’s annuitized share in expected future productivity of a worker can either only barely, or even no longer at all break even the annuitized lower bound of the costs the firm faces. Vacancies become unprofitable and the economy quickly enters a downward spiral. The core of the mechanism relies critically on an unreasonably high and constant flow value of unemployment. Disasters disappear entirely for slightly smaller or procyclical values and the effects cannot be compensated by empirically plausible adjustments of the model’s remaining parameters. While the model can generate a sizeable equity premium combined with a small risk-free rate if the flow value of unemployment is large and constant and if the coefficient of relative risk aversion and the elasticity of intertemporal substitution are both high, premia again collapse by an order of magnitude in the versions of the model without disasters.