1. The interest rate on a one-year bond is 0.5% and that the market currently expects the interest rate on a one-year bond to remain at 0.5% next year and the following year.

a)Using Pure Expectations Theory, calculate the current two-year and three-year spot rates.

2. Suppose the CB announces that it is concerned about signs of increasing inflation and states that is plans to have to start raising short-term rates starting next year. Suppose further that the CB announces it plans to take action to increase the one-year bond rate to 0.75% next year and to 1.0% the following year and that the market believes the CB. Calculate what will happen to the current two-year and three-year spot rates right now.