As pointed out by many studies, [Boldrin, Christiano and Fisher (2001), Danthine and Donaldson (2002), Uhlig (2006), Uhlig(2007), Guvenen (2009)] the endogeneity of labor market movements is a major obstacle when it comes to explaining the joint behavior of financial market and macroeconomic data. In this article, we propose to overcome this difficulty by considering an economy with a representative agent whose habits are formed over a mix of consumption and leisure.
In a model with endogenous labor supply, the stochastic discount factor and the labor-leisure decision are jointly determined. Variations in marginal utility jointly affect the stochastic discount factor used to price assets and agents’ willingness to supply labor. Introducing endogenous labor supply therefore enriches the set of predictions of asset pricing models. This information can then be exploited to refine our understanding of asset pricing puzzles by considering models with a richer set of empirical implications.
As far as the labor market is concerned, the facts that hours worked are volatile and strongly procyclical and that real wages are sluggish are the key empirical regularities which must be explained. As emphasized by Uhlig (2006, 2007), the challenging task is to reproduce these empirical labor market regularities in a model also able to explain asset pricing puzzles. The key difficulty stems from the fact that the resolution of asset pricing puzzles requires the introduction of mechanisms producing volatile and countercyclical movements in marginal utility. While this feature is needed to generate plausible asset pricing predictions, in models with a labor-leisure decision, it comes at the cost of creating large wealth effects on labor supply.
Large wealth effects on labor supply induce agents to reduce labor effort in periods of economic booms and therefore impairs the ability of standard macroeconomic models to explain the positive correlation between hours worked and output observed in the data. Intuitively, a rise in the volatility of marginal utility, while needed to explain high risk premia, generates an increase in uncertainty which hurts the agents. In a model with endogenous labor supply, this additional margin can be used to offset the undesirable effects of an increase in uncertainty. This negative wealth effect leading to a counterfactual decline in the volatility of hours worked therefore captures that agents would rather choose to reduce labor effort in good times, since reducing (increasing) labor effort in periods of economic booms (recessions) helps to reduce the volatility of output. Such a reduction in the volatility of output makes the whole economy less risky and allows agents to better insure their consumption against shocks.
The concept of habit formation that we propose to introduce permits to successfully resolve this tension between the asset pricing and the business cycle implications of models with endogenous labor supply. As in any asset pricing model, in our economy, a rise in habit intensity increases the volatility of marginal utility. The key is that this increase in intensity also leads to a reduction in the wealth elasticity of labor supply which decreases the sensitivity of labor supply to movements in marginal utility. Our mechanism, which crucially relies on this joint impact of habit formation, appears to improve the ability of an otherwise standard real business cycle model to jointly explain asset pricing and business cycle facts.
