### Expected inflation rate in the second year

##### Reference no: EM131093440

1) The rate of inflation for the coming year is expected to be 3 percent, and the rate of inflation in Year 2 and thereafter is expected to remain constant at some level above 3 percent. Assume that the real risk-free rate, r*, is 2 percent for all maturities and the expectations theory fully explains the yield curve, so there are no maturity premiums. If three-year Treasury bonds yield two percentage points more than one- year bonds, what rate of inflation is expected after Year 1?

2) Assume that the real risk-free rate is 4 percent and the maturity risk premium is zero. If the nominal rate of interest on one-year bonds is 11 percent, and on comparable-risk two-year bonds it is 13 percent, what is the one-year interest rate that is expected for Year 2? What inflation rate is expected during Year 2?

3) The interest rate on one- year Treasury bonds is 2.2 percent, the rate on two- year Treasury bonds is 3.0 percent, and the rate on three-year Treasury bonds is 3.6 percent. These bonds are considered risk free, so the rates given here are risk- free rates (rRF). The one-year bond matures one year from today, the two-year bond matures two years from today, and so forth. The real risk- free rate (r*) for all three years is 2 percent. Using the expectations theory, compute the expected inflation rate in the second year (i.e., the 12-month period that begins one year from today).

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