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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 1.5%. If the yield on 3-year Treasury bonds equals the 1-year yield plus 1.5%, what inflation rate is expected after Year 1?

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Expert Solution

Solution :

Yield on 1-year Treasury Bond = Real Risk-free Rate + Inflation Premium on 1-year Treasury Bond

Yield on 1-year Treasury Bond = 1.50% + 2.75%

Yield on 1-year Treasury Bond = 4.25%

Yield on 3-year Treasury Bond = Real Risk-free Rate + Inflation Premium on 3-year Treasury Bond

Yield on 3-year Treasury Bond = 1.50% + Inflation Premium on 3-year Treasury Bond

Yield on 3-year Treasury Bond = Yield on 1-year Treasury Bond + 1.50%

1.50% + Inflation Premium on 3-year Treasury Bond = 4.25% + 1.50%

1.50% + Inflation Premium on 3-year Treasury Bond = 5.75%

Inflation Premium on 3-year Treasury Bond = 4.25%

Inflation Premium on 3-year Treasury Bond = Average Inflation over next 3 years

4.25% = [2.75% + 2 * Inflation for Year 2 and thereafter] / 3

12.75% = 2.75% + 2 * Inflation for Year 2 and thereafter

10.00% = 2 * Inflation for Year 2 and thereafter

Inflation for Year 2 and thereafter = 5.00% or 5%

please like the answer.....

Rahul Sunny answered 2 years ago
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