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

In dynamic stochastic general equilibrium (DSGE) models, the household’s labor margin as well as consumption margin affects Arrow-Pratt risk aversion. This paper derives simple, closed-form expressions for risk aversion that take into account the household’s labor margin. Ignoring the labor margin can lead to wildly inaccurate measures of the household’s true attitudes toward risk. We show that risk premia on assets computed using the stochastic discount factor are proportional to Arrow-Pratt risk aversion, so that measuring risk aversion correctly is crucial for understanding asset prices. Closed-form expressions for risk aversion in DSGE models with generalized recursive preferences and internal and external habits are also derived.