1.Assume that the current 1-year interest rate is 3%, the expected 1-year rate next year is 2%, and the expected 1-year rate in the following year (3^rdyear) is 4%.

a.Calculate the 2-year interest rate and the 3-year interest rate based on the expectations theory. (Show calculations)

b.Draw the yield curve based on your data above. Label your axis and mark the numbers along the axis, so you can read the actual interest rates in your graph. (This doesn't need to be 100% precise, but your graph should look consistent with the numbers. Sloppy graphs will lose points.)

c.Assume that investors want a liquidity premium with a higher compensation for holding long-term bonds. Add the liquidity premium in your graph above. Make clear which curve is based only on the expectations theory and which takes into consideration the liquidity premium.

d.Based on this yield curve: What do you think market participants expect from future inflation and the economy (Write brief answers.)

(i)in the next 2 years?

(ii)From year 3?