The Term Structure of Interest Rates in an Equilibrium Economy with Short Term and Long Term Investments

Abstract

This paper develops an equilibrium model in which agents’ heterogeneous investment horizons determine the dynamics of the real term structure of interest rates. The model endogenizes agents’ decisions on consumption and investment with short and long term horizons. There are two production technologies that generate a time-varying market price of risk, one that is short term and fully reversible and one that is a long term time-to-build technology. The model is calibrated with U.S. data from 1970 to 2007 using Simulated Method of Moments and captures several results and stylized facts, such as: (i) the excess returns on short and long term investments together with a low volatility of consumption using a reasonably low risk aversion parameter; (ii) a low correlation between long term investments (e.g. direct investments in real estate) and short term investments; and (iii) the slightly positive slope of the real term structure of interest rates.