Aggregate Asset Pricing with Labor Market Frictions ∗

Even though labor income represents about two thirds of disposal income to household, its role has largely been neglected by asset pricing models. In this paper, we solve a general equilibrium model which can both rationalize important feature of labor markets as well as financial markets. To this end, we embed labor market search frictions into a business cycle model where the representative household has recursive Epstein-Zin preferences. We find that the model is consistent with the cyclical behavior of the unemployment rate. The model also replicates the volatility of labor market tightness seen in the data. Crucially, for asset prices, aggregate employment and output react progressively to innovations and the model delivers a high degree of persistence in the growth rate of aggregate output and consumption. This endogenous persistence in combination with recursive Epstein-Zin preferences increase the equity risk premium considerably. JEL Classification: E21, E24, E40, G12.