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The Term Structure Of Interest Rates In An Equilibrium Economy With Short Term And Long Term Investments

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Executive Summary

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 investments 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 equivalent to a long term time-to-build technology. The paper shows that the ratio of long to short term capital invested in these technologies is a key factor that influences the term structure and provides specific formulas for the equilibrium real short interest rate, bond prices, and consumption dynamics that are functions of this ratio.

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