Labor market frictions help explain the credit spread puzzle. In U.S. aggregate data and newly assembled U.S. industry-level and cross-country panel datasets, the relation between unemployment and credit risk is strong and positive. In a search model of equilibrium unemployment embedded with defaultable debt and capital accumulation, search frictions create downward rigidity in expected search costs, hindering firms from repaying creditors particularly in bad times and rendering corporate debt riskier. Quantitatively, the model replicates the strongly positive relation between unemployment and credit risk as well as salient features of the credit spread, including its level, volatility, cyclicality, and skewness.

A dynamic stochastic general equilibrium model with recursive utility, search frictions, and capital accumulation is a good start to forming a unified theory of asset prices and business cycles. The model reproduces an equity premium of 4.27% per annum, a stock market volatility of 12.42%, and an average interest rate of 1.97%, while retaining plausible business cycle dynamics. The equity premium and stock market volatility are strongly countercyclical, whereas the interest rate and consumption growth are largely unpredictable. Because of wage inertia, dividends are procyclical despite consumption smoothing via investment. The welfare cost of business cycles is huge, 33.6%.