Assume that it is now January 1. The rate of inflation is expected to be 4 percent throughout the year. However, increased government deficits and renewed vigor in the economy are then expected to push inflation rates higher. Investors expect the inflation rate to be 5 percent in Year 2, 6 percent in Year 3, and 7 percent in Year 4. The real risk-free rate, r*, is expected to remain at 2 percent over the next 5 years. Assume that no maturity risk premiums are required on bonds with 5 years or less to maturity. The current interest rate on 5-year T-bonds is 8 percent.

a. What is the average expected inflation rate over the next 4 years?

b. What should be the prevailing interest rate on 4-year T-bonds?

c. What is the implied expected inflation rate in Year 5, given that Treasury bonds which mature at the end of that year yield 8 percent?