Implications of Labor Market Frictions for Risk Aversion and Risk Premia

A flexible labor margin allows households to absorb shocks to asset values with changes in hours worked as well as changes in consumption. This ability to absorb shocks along both margins can greatly alter the household's attitudes toward risk, as shown by Swanson (2012a). The present paper analyzes how those results are affected by labor market frictions and shows that: 1) risk aversion is higher in recessions, 2) risk aversion is higher in more frictional labor markets, and 3) risk aversion is higher for households that are less employable. Quantitatively, labor market flow rates in the U.S. and other OECD countries are large relative to the discount rate, implying that the cost of labor market frictions is small because frictions only delay adjustment. Thus, the frictionless formulas in Swanson (2012a,b) appear to be very good approximations in frictional labor markets as well.