Preferred habitat and the term structure of interest rates in DSGE models

ABSTRACT The aim of the present study is to use an alternative approach to derive the term structure of interest rates in DSGE models, which is based on the theory of preferred habitat. We show that this approach yields a substantial term premium which is time-variant. In particular, by introducing bonds of longer maturity, we avoid the underestimation of the volatility of the output. In addition, by allowing longer-term bonds, we show that output is more responsive to technology shocks than it would otherwise. Therefore, the goal of stabilizing output around the nonstochastic level is more difficult to achieve