Asset prices in a labor search model with confidence shocks

Abstract

This paper studies a labor search model with agents who are averse to ambiguity (Knightian uncertainty). Shocks to confidence about future productivity are modeled as changes in ambiguity. Using the Survey of Professional Forecasters data, I find that confidence shocks help explain the equity premium and the stock market volatility, including their term structure. Ambiguity amplifies the response of the economy to productivity shocks, helping the model produce more realistic dynamics of unemployment, vacancies, labor market tightness, stock prices, and returns. Returns in the model are predictable with price-dividend ratios; both returns and dividends are predictable with unemployment, like in the data. Two extensions consider shocks to bargaining power and to separation rate and find similar implications of ambiguity about these shocks.