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The bond premium in a DSGE model with long-run real and nominal risks

  • Glenn D. Rudebusch
  • Eric T. Swanson

The term premium on nominal long-term bonds in the standard dynamic stochastic general equilibrium (DSGE) model used in macroeconomics is far too small and stable relative to empirical measures obtained from the data--an example of the ''bond premium puzzle.'' However, in models of endowment economies, researchers have been able to generate reasonable term premiums by assuming that investors have recursive Epstein-Zin preferences and face long-run economic risks. We show that introducing Epstein-Zin preferences into a canonical DSGE model can also produce a large and variable term premium without compromising the model's ability to fit key macroeconomic variables. Long-run real and nominal risks further improve the model's ability to fit the data with a lower level of household risk aversion.

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Paper provided by Federal Reserve Bank of San Francisco in its series Working Paper Series with number 2008-31.

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Date of creation: 2008
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Handle: RePEc:fip:fedfwp:2008-31
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