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

62 Pages Posted: 16 Apr 2003  

Andrea Buraschi

The University of Chicago; Imperial College Business School; Centre for Economic Policy Research (CEPR)

Alexei Jiltsov

London Business School; Lehman Brothers, New York

Date Written: December 2003

Abstract

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.

Keywords: Term structure, bond prices, habit persistence, time non-separable preferences

JEL Classification: D9, E3, E4, G12

Suggested Citation

Buraschi, Andrea and Jiltsov, Alexei, Term Structures of Interest Rates and Inflation in Economies With Habit Formation (December 2003). Available at SSRN: https://ssrn.com/abstract=374161 or http://dx.doi.org/10.2139/ssrn.374161

Andrea Buraschi (Contact Author)

The University of Chicago ( email )

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7738347123 (Phone)

HOME PAGE: http://www.andreaburaschi.com/

Imperial College Business School ( email )

South Kensington Campus
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London SW7 2AZ, SW7 2AZ
United Kingdom

HOME PAGE: http://www.andreaburaschi.com/

Centre for Economic Policy Research (CEPR)

77 Bastwick Street
London, EC1V 3PZ
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Alexei Jiltsov

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom

Lehman Brothers, New York ( email )

745 Seventh Avenue
New York, NY 10285
United States

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