The rate of inflation for the coming year is expected to be 3 percent

QUESTION

The rate of inflation for the coming year is expected to be 3 percent and the rate of inflation in Year 2 and thereafteris respected to remain constant at some level above 3 percent. Assume that the real risk-free rate r* is 2 percent for all maturities and the expectations theory fully explains the
According to the given information,Inflation in year-1 = 3%Inflation in year-2 = 3% XReal risk free rate (r*) = 2%I2 = ?But given that the 3-year treasury bonds yield 2% more than one-year bonds.r3 = r1 2%But r1 = r* IP = 2% 3% = 5%Knowing r1, we can calculate the value of

r3. r3 = r1 2% = 5% 2% = 7%But r3 = r* IP3 7% = 2% IP3 7% = 2% [3% (3% X) (3% X)] / 3 5% = (2X 9%) / 3 15% = 2X 9% 2X = 6% X = 3%Therefore, inflation in year-2 is (3% X) = 3% 3% = 6%

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