Due to a recession, expected inflation this year is only 3%. However, the inflat

Question

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

Explanation / Answer

One year yield = r* + average inflation

                        = 3% + 3%

                        = 6%

So three year yield is expected to be 6%+3% = 9%.

Now we can again use the yield formula to compute inflation rate

3 year yield = r* + 3 year average inflation

          9% = 3% + (3% +IR +IR)/3

          18% = 3%+ 2 IR

          IR= (18%-3%)/ 2

              = 7.50%

Therefore, inflation rate after year 1 would be 7.50%.

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