This paper investigates the term structure implications of a simple structural model with nonseparable preferences and habit formation. The distinguishing features of the model are that the drift of equilibrium spot interest rates is non-linear, interest rates depend on lagged values of monetary and consumption shocks, and the price of risk is not a constant multiple of interest rates volatility. We solve the model in closed-form and investigate its empirical properties. We find that habit persistence can help reproduce (i) the non-linearity of the spot rate process, (ii) the empirical Campbell and Shiller (1991) linear projection coeffcients and the documented deviations from the expectations hypothesis, (iii) the extent of the persistence of conditional volatility of interest rates, (iv) the lead/lag relationship between interest rates and monetary aggregates, and (v) the dynamics of the inflation risk premium. We also describe the limitations of this particular form of habit persistence. Although the model improves some traditional models with respect to several dimensions, its ability to reproduce, at the same time, the equity risk premium and the conditional second moments of interest rates is still limited.
Imperial College London