Are prices sticky? This simple question has been at the cornerstone of heated discussions in macroeconomics for several decades. Price rigidities can potentially be an amplifying force for business cycle fluctuations and are the leading explanation for the effectiveness of monetary policy to stimulate the real side of the economy. Large-scale micro pricing datasets unambiguously show that prices at the micro level indeed adjust infrequently. This finding has moved the discussion about the existence of price stickiness to the question of whether or not they matter for the real economy. In my dissertation, I first address this question using information in the stock market valuation of firms. I then use information on the price stickiness of individual firms to better understand firms' exposure to systematic risk and the cross section of stock returns.

In the first chapter of my dissertation which is co-authored with Yuriy Gorodnichenko, I investigate whether sticky prices are costly and burden firms. A central tenet of New Keynesian models is that firms face costs of price adjustments or other rigidities that hinder them from adjusting output prices once hit by nominal or real shocks. Models in the tradition of the New Monetarist search literature instead suggest that sticky prices are an equilibrium outcome. These models generate sticky prices at the micro level even though firms could adjust prices at each instant in time without any costs. Both classes of models have vastly different implications for policy and business cycles. The key insight of this chapter is that sticky price firms should have a larger responsiveness of profits, returns, and volatilities to nominal or real shocks compared to flexible price firms in New Keynesian models, while New Monetarist search models predict an equal reaction across firms with different price stickiness. I show that after monetary policy announcements, the conditional volatility of stock market returns rises more for firms with stickier prices than for firms with more flexible prices. This differential reaction is economically large as well as strikingly robust to a broad array of checks. These results suggest that menu costs -- broadly defined to include physical costs of price adjustment, informational frictions, etc. -- are an important factor for nominal price rigidity. I also show that my empirical results are qualitatively and, under plausible calibrations, quantitatively consistent with New Keynesian macroeconomic models in which firms have heterogeneous price stickiness. Since the framework is valid for a wide variety of theoretical models and frictions preventing firms from price adjustment, I provide "model-free" evidence that sticky prices are indeed costly for firms. My findings provide support for workhorse models with sticky prices at policy institutions and imply that nominal rigidities are a central force for the real effects of monetary policy.

The second chapter examines the asset-pricing implications of nominal rigidities. I find that firms that adjust their product prices infrequently earn a cross-sectional return premium of more than 4% per year. Merging confidential product price data at the firm level with stock returns, I document that the premium for sticky-price firms is a robust feature of the data and is not driven by other firm and industry characteristics. The consumption-wealth ratio is a strong predictor of the return differential in the time series, and differential exposure to systematic risk fully explains the premium in the cross section. The sticky-price portfolio has a conditional market beta of 1.3, which is 0.4 higher than the beta of the flexible-price portfolio. The frequency of price adjustment is therefore a strong determinant of the cross section of stock returns. To rationalize these facts, I develop a multi-sector production-based asset-pricing model with sectors differing in their frequency of price adjustment. My results show that nominal rigidities are not only central in macroeconomics for business cycle fluctuations and the real effects of nominal shocks but are also a strong determinant of the cross section of stock returns. To the extent that firms equalize the costs and benefits of price adjustment the higher cost of capital for firms with stickier prices can provide a holistic measure for the cost of price adjustment.

My dissertation shows that price rigidities explain both business-cycle dynamics in aggregate quantities and cross-sectional variation in stock returns, and further bridge macroeconomics and finance.

The current thesis presents three chapters in finance that investigate how a firm's characteristics affect its internal corporate financing decision as well as the external perception of the firm by the financial market. The paper advances empirical asset pricing by studying how the market's expectations about firms vary systematically with firms' profitabilities and the impact of these expectations on stock prices. Further, the paper adds to corporate finance by investigating new channels through which firms determine their capital structure and compensation contract for their executives.

Previous research indicated that sorting firms by their profitabilities generates sizeable cross-sectional variations in subsequent period stock returns. Firms that have high profitability this period tend to outperform low profitability firms in the next period. The first chapter of this paper investigates whether high profit firms have higher returns because they are fundamentally riskier in some way, or whether mispricing drives the return difference. The chapter presents evidence that the premium associated with profitability is difficult to reconcile with risk-based explanations but is consistent with expectation errors. Firms with a lower profitability prove more volatile, suffer greater drawdowns and are more sensitive to macroeconomic conditions. This means that the profitable firms are actually less risky by most measures and perform better during economic downturns. In addition, a monotonic relationship exists between profitability and forecast error. Stock analysts tend to be overoptimistic for low profitability firms relative to high profitability firms. Surprisingly, this mis-expectation can persist for as long as five years into the future. Furthermore, the profitability premium is mainly concentrated among firms about which the anlysts express the most optimism.

The second chapter, jointly authored with Francesco D'Acunto, Carolin Pflueger and Michael Weber, shows that the frequency with which firms adjust output prices is an important determinant of persistent capital structure. Using restricted BLS data, we constructed a measure of the individual firm's output price rigidity and matched it with financial information of the firm. Flexible-price firms choose higher financial leverage than inflexible-price firms, controlling for known determinants of capital structure. We rationalize this novel fact using a costly-state-verification model, where inflexible-price firms are more exposed to aggregate shocks, and hence face tighter financial constraints. The model predicts that bank lending, by providing monitoring, relaxes financial constraints and narrows the leverage gap between inflexible- and flexible-price firms. Consistent with model predictions, we show that inflexible-price firms increased leverage more than did flexible-price firms following the staggered implementation of the 1994 repeal of interstate bank branching regulations. Firms' frequency of price adjustment did not change around this deregulation, supporting a causal interpretation of price flexibility on corporate leverage.

In the third chapter of the dissertation, I investigate the role that innovation plays in executive compensation. Agency-based theory of optimal executive compensation literature has long puzzled over the empirical observation that executives are being compensated for industry performances that are outside the executive's control. Using patent-based metrics as the measure of innovativeness, I show that this “pay for luck” phenomenon is mainly concentrated among the most innovative firms and is stronger for firms in more innovative industries. I conjecture that motivating innovation might require a different contract design,and in some cases, “pay for luck” might actually be optimal in incentivizing experimentation.

This dissertation explores the relationship between international financial markets, financial frictions, and the real economy. In particular, the dissertation focuses on the role of the United States of America (US) as the key country in the global financial architecture. The research presented here advances the study of international finance and macroeconomics by analyzing how the combination of two factors, the greater financial development of the US and financing frictions, leads to the special global roles of the US funding markets and the US dollar.

In the first Chapter of the dissertation, I develop a model of financial intermediation in a closed economy, which is also the key building block of the open economy analysis in the second Chapter. In an economy with savers and financial intermediaries where financing frictions are present, the state of the financial sector becomes the key state variable. The financing frictions, modeled as the limited enforceability of deposit contracts, prevent capital from flowing freely from savers to the financial intermediaries that ultimately allocate capital to productive real assets. When financial intermediaries are well capitalized, their capital acts as a safety buffer for potential investment losses and, consequently, financing frictions are alleviated. In this state of the world, financial markets closely resemble those of the standard frictionless asset pricing framework. When, on the other hand, intermediaries are poorly capitalized, concerns for potential losses of capital disrupt the financing markets. In this state of the world, capital does not flow smoothly from savers into productive assets via financial intermediaries. In general, risky assets' prices fall and their volatility increases, thus replicating typical features of financial crises. Interestingly, these effects are highly non-linear.

In the second Chapter, I provide a framework for understanding the global financial architecture as an equilibrium outcome of the risk sharing between countries with different levels of financial development. The country that has the most developed financial sector takes on a larger proportion of global fundamental and financial risk because its financial intermediaries are better able to deal with funding problems following negative shocks. This asymmetric risk sharing has real consequences. In good times, and in the long run, the more financially developed country consumes more, relative to other countries, and runs a trade deficit financed by the higher financial income that it earns as compensation for taking greater risk. During global crises, it suffers heavier capital losses than other countries, exacerbating its fall in consumption. This country's currency emerges as the world's reserve currency because it appreciates during crises and so provides a good hedge. The model is able to rationalize these facts, which characterize the role of the US as the key country in the global financial architecture.

In the third Chapter, I provide empirical evidence on the role of the US dollar as a global safe asset. This empirical evidence provides one of the stylized facts analyzed in my theoretical work. I show that the US dollar earns a safety premium versus a basket of foreign currencies and that this premium is particularly high in times of global financial stress. These findings support the view that the dollar acts as the reserve currency for the international monetary system and that it is a natural safe haven in times of crisis, when a global flight to quality toward the reserve currency takes place. During such episodes, investors are willing to earn negative expected returns as compensation for holding safe dollars. I estimate the time varying dollar safety premium by using instrumental variable techniques to condition information down.

The downside risk CAPM (DR-CAPM) can price the cross section of currency returns. The market-beta differential between high and low interest rate currencies is higher conditional on bad market returns, when the market price of risk is also high, than it is conditional on good market returns. Correctly accounting for this variation is crucial for the empirical performance of the model. The DR-CAPM can jointly explain

the cross section of equity, commodity, sovereign bond and currency returns, thus offering a unified risk view of these asset classes. In contrast, popular models that have been developed for a specic asset class fail to jointly price other asset classes.