Sadaf Tara ork PM EDT Module 3 Homework Assignment Sco Save Submit Assignment fo

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Sadaf Tara ork PM EDT Module 3 Homework Assignment Sco Save Submit Assignment for d Problem 6.10 e Question Check My Work (2 remaini Click here to read the eBook: The Determinants of Market Interest Rates INFLATION Due to a recession, expected inflation this year is only 2.5%. However, the inflation rate in Year 2 and thereafter is expected to be Assume that expected after Year 1? Round your answer to two decimal places. constant at some level above 25%. 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 ination rate Hide Feedback Incorrect Cheek My Work (a remaining)

Explanation / Answer

Expected inflation this year =2.5%

Inflation from next year < 2.5%
Risk-free rate (r*)=3%

The yield on three-year bond= Yield of 1 year+3%

We know that I1 = IP1 =2.5% and r* = 3%. Therefore,

RT1 = 3% + 2.5% = 5.5%.

RT3 = RT1 + 3% = 5.5% + 3% = 8.5%.

RT3 = r* + IP3 = 3% + IP3 = 8.5%, so

IP3 = 8.5% – 3% = 5.5%.

Now,

IPt r = r* + IPt (We are averaging inflation for first 2 years)

IP3= 5.5 = (2.5% + 2IP)/3

16.5 = 4 + 2IP

2IP = 12.5

IP = 6.25%

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