Question

# Due to a recession, expected inflation this year is only 3%. However, the inflation rate in...

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.

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%

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