This paper is a progress report on understanding the relationship betweenprices and allocations of risks on financial markets versus macroeconomicchoices and allocations. In this paper, I investigate the scope of a modelwith exogenous habit formation or catching up with the Joneses, seeAbel (1990) to generate the observed equity premium as well as other keymacroeconomic facts. Along the way, I derive restrictions for four out of eightparameters for a rather general preference specification of habit formation byimposing consistency with long-run growth, the leisure share, the aggregateFrisch elasticity of labor supply, the observed risk-free rate, and the observedSharpe ratio.
The high reward for holding risk on financial markets implies that thestochastic discount factor of the marginal investor shows large fluctuations,which are highly correlated with aggregate risk. Models with a representativeagent - to which this paper belongs - therefore require, that risk aversion,measured appropriately, must be high. That alone, however is not enough:when economic choices are endogenous, agents typically have the possibilityto insulate the risk-sensitive dimensions of their preferences against aggregaterisk.
Thus, the literature on generating both asset pricing facts as well asmacroeconomic facts within one model has increasingly pointed to labor market frictions as possibly important for a joint explanation. Endogenous laborsupply decisions on a frictionless labor market provide agents with an insur-ance device against fluctuations in consumption. This insurance possibilitythen renders these models incapable of generating high Sharpe ratios or eq-uity premia, unless additional frictions on labor markets such as separatedlabor markets or wage rigidities are introduced, see e.g. Lettau and Uhlig(2000), Boldrin, Christiano and Fisher (2001), Fatih Guvenen (2003) or Uh-lig (2006). Furthermore, wage rigidities have recently been emphasized askey to understanding aggregate fluctuations more generally, see e.g. Ha
