The Bond Premium in a DSGE Model with Long-Run Real and Nominal Risks

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 fi…t 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.