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 3.5%. If the yield on 3-year Treasury bonds equals the 1-year yield plus 3.5%, what inflation rate is expected after Year 1? Round your answer to two decimal places.

Answer 1

rate=real rate+default risk premium+maturity risk premium+liquidity risk premium+infaltion premium
Under Pure expectations theory and For Treasury bonds, default risk premium and liquidity risk premium are zero..Also, maturity risk premium=0
rate on 1year TBond=real rate+inflation premium
Hence, rate on 1 year Treasury bond=3.5%+3%=6.5%
rate on 3 year Treasury bond is given as 6.5%+3.5%=10%
=>3.5%+Average Inflation premium=10%
So, average inflation premium=6.5%
=>Inflation Premium 1+Inflation Premium 2 + Inflation Premium 3=6.5*3=19.5%
Now we know Inflation Premium 1=3.5% and Inflation Premium 2=Inflation Premium 3
So, Inflation Premium 2=(19.5%-3.5%)/2=8%​