HABIT PERSISTENCE AND THE NOMINAL TERM PREMIUM PUZZLE - A PARTIAL RESOLUTION

The assumption of habit formation in preferences induces two effects o n time series of agents' marginal utility of consumption: greater vola tility relative to standard time-separable preferences and negative se rial correlation. This paper examines whether the second property can help explain the behavior of the nominal term premium. A cash-in-advan ce model of interest rates is appended with a model cf habit persisten ce and calibrated to U.S. data. Using yields on three- and six-month U .S. Treasury Bills for comparison, we find the model can indeed duplic ate the observed average term premium, but cannot account for the term premium's volatility.