The expected inflation rate after a year. Expectation Theory: Expectation theory estimates the future interest without taking maturity risk into consideration. According to the expectation theory, the yield curve of investment totally depends upon the future expectation of investors.

Question

Due to a recession, expected inflation this year is only 1.75%. However, the inflation rate in Year 2 and thereafter is expected to be constant at some level above 1.75%. 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 0.5%, what inflation rate is expected after Year 1? Round your answer to two decimal places.

Answer 1

Question

Chapter 6, Problem 10P

Summary Introduction

To identify: The expected inflation rate after a year.

Expectation Theory:

Expectation theory estimates the future interest without taking maturity risk into consideration. According to the expectation theory, the yield curve of investment totally depends upon the future expectation of investors.

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