Term Structures of Interest Rates and Inflation in Economies With Habit Formation

This paper solves in closed-form a continuous time model of the nominal and real term structures of interest rates in a monetary economy with habit formation. A crucial property is that, unlike in affine specifications, the price of risk is not a constant multiple of the volatility of interest rates but it depends on the state of the economy. In bad (good) states, investors become more (less) risk averse. We take the model to the data and explore its ability to explain the dynamics of the term structure of interest rates. We find that, compared to affine specifications, the model with habit persistence finds it easier to reproduce (i) the empirical Campbell and Shiller (1991) slope coefficients and the documented deviations from the expectation hypothesis, (ii) the extent of the persistency of the conditional volatility of interest rates, (iii) the lead/lag relationship between interest rates and monetary aggregates, and (iv) the dynamics of the inflation risk premium