Due to a recession, expected inflation this year is only 2.75%. However, the inflation rate in...

Due to a recession, expected inflation this year is only 2.75%. However, the inflation rate in Year 2 and thereafter is expected to be constant at some level above 2.75%. Assume that the expectations theory holds and the real risk-free rate (r*) is 2.5%. If the yield on 3-year Treasury bonds equals the 1-year yield plus 1.5%, what inflation rate is expected after Year 1? Round your answer to two decimal places

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Expert Solution

year 1 yield=2.5%+2.75%=5.25%

year 3 yield=5.25%+1.5%=6.75%

year 3 yield=6.75%

2.5%+(2.75%+inflation rate after year 1*2)/3=6.75%

inflation rate after year 1=(((6.75%-2.50%)*3)-2.75%)/2

=5.00% is answer

jeff jeffy answered 2 years ago

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