Term structure of interest rates under recursive preferences in continuous Time

This paper proposes a testable continuous-time term-structure model with recursive utility to investigate structural relationships between the real economy and the term structure of real and nominal interest rates. In a representative-agent model with recursive utility and mean-reverting expectations on real output growth and inflation, this paper shows that, if (1) real short-term interest rates are high during economic booms and (2) the agent is comparatively risk-averse (less risk-averse) relative to time-separable utility, then a real yield curve slopes down (slopes up, respectively). Additionally, for the comparatively risk-averse agent, if (3) expected inflation is negatively correlated with the real output and its expected growth, then a nominal yield curve can slope up, regardless of the slope of the real yield curve. © 2009 Springer Science+Business Media, LLC.