It is January 1, 2008. Inflation currently is about 2 percent; throughout 2007 t

Question

It is January 1, 2008. Inflation currently is about 2 percent; throughout 2007 the Fed took action to maintain inflation at this level. Now the economy is starting to grow too quickly and reports indicate that inflation is expected to increase during the next five years. Assume that at the beginning of 2008, the rate of inflation expected for 2008 is 4 percent; for 2009 it is expected to be 5 percent; for 2010 it is expected to be 7 percent; and for 2011and every year thereafter, it is expected to settle at 4 percent.

A. What is the average expected inflation rate over the five-year period 2008-2012? (Use the arithmetic average.)
B. What average nominal interest rate would, over the five-year period, be expected to produce a 2 percent real risk-free rate of return on five-year treasury securities

Explanation / Answer

a) According to the given information, Inflation rate in 2008 = 4% 2009 = 5% 2010 = 7% 2011 = 4% 2012 = 4% Average expected inflation rate over the five-year period = (4% + 5% + 7% + 4% + 4%) / 5 = 4.8% Therefore, the average expected inflation rate is 4.8% b) In the part-2, the risk free rate of returnis 2% r = r* + IP5 = 2% + 4.8% = 6.8% Therefore, the expected average nominal rate of interest over the five year period is 6.8%

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