Risk Aversion, the Labor Margin, and Asset Pricing in DSGE Models

Abstract

In dynamic equilibrium models, the household's labor margin has dramatic effects on risk aversion, and hence asset prices, even when utility is addi-tively separable between consumption and labor. This paper derives simple, closed-form expressions for risk aversion that take into account the house-hold's labor margin. Ignoring the labor margin can wildly overstate the household's true aversion to risk. Risk premia on assets priced with the stochastic discount factor increase essentially linearly with risk aversion, so measuring risk aversion correctly is crucial for asset pricing in the model. Closed-form expressions for risk aversion in DSGE models with generalized recursive preferences and internal and external habits are also derived.