6. You are considering the choice between investing $50,000 in a conventional 1-year bank CD offering an interest rate of 5% and a 1-year “Inflation-Plus” CD offering 1.5% per year plus the rate of inflation.

a. Which is the safer investment?

b. Which offers the higher expected return?

c. If you expect the rate of inflation to be 3% over the next year, which is the better investment?

Why?

d. If we observe a risk-free nominal interest rate of 5% per year and a risk-free real rate of 1.5%

on inflation-indexed bonds, can we infer that the market’s expected rate of inflation is 3.5%

per year?