Term Structure Dynamics in a Model with Stochastic Internal Habit

The expectations hypothesis is violated in the U.S. nominal term structure of interest rates. This so-called ”expectations puzzle” can be captured by some descriptive models of the term structure with time-varying risk premium. This paper provides an economic explanation for the success of these reduced-form specifications of pricing kernels. Specifically, we show that a consumption-based asset pricing model with stochastic internal habit, when calibrated to aggregate real macroeconomic and asset market data, generates market prices of risk with all of the requisite properties to resolve the expectations puzzle.