We present a tractable general equilibrium model with multiple sectors in which firms offer workers incentive contracts and simultaneously raise capital in stock markets. Workers optimally invest in the stock market and at the same time hedge labour income risk. Firms rationally take agents' portfolio decisions into account. In equilibrium, the cost of capital of each sector is endogenous. The distortion induced by moral hazard generates counterintuitive effects on the real economy. For example, the value of labour market participation may be higher under moral hazard than under first best, further a positive productivity shock may decrease welfare in the moral hazard economy. In addition, our model generates predictions on the effects of moral hazard on asset markets. For example, in the presence of moral hazard, the capital asset pricing model fails because firms, by choosing optimal incentive contracts, transfer risk both through wages and through the stock market. This leads to several cross-sectional asset pricing "anomalies", such as size and value effects. As we characterize optimal contracts, we can also present empirical predictions relating workers' compensation, firm productivity, firm size, and financial market abnormal returns.
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