"That" is actually better here, although both would work.
Using "that" like this is very common in hypothetical statements:
"Once upon a time, there was a magical kingdom. And in [this/that/the] kingdom, there lived a princess."
My intuition tells me "that" sounds better, because "that" sounds like we're distinguishing something (in this case, the kingdom) from some other thing (like another kingdom), and neither of them are immediately visible.
It's all just a matter of preference though.
P.S. There's actually a song which uses this hypothetical "that" over and over again. It's called And The Green Grass Grew All Around. Here are the lyrics:
Oh in the woods there was a tree
The prettiest tree
You ever did see
And the tree was in the ground
And the green grass grew all around, all around, and the green grass grew all around
And on that tree
There was a limb
The prettiest limb
That you ever did see
And the limb was....
And on that limb
There was a branch
The prettiest branch....
So you can see that the pattern goes from 'a' --> 'the' --> 'that'.
"A tree," to introduce the object "tree."
"The prettiest tree," to specify that it's not just any tree, it's the tree.
"That tree," to indicate that you're talking about the tree that you were just saying something about earlier.
That's kind of the best way I can explain it.