a. What effect would each of the following events likely have on the level of nominal interest rates?

Households dramatically decrease their savings rate.

This action will (increase or decrease)

the supply of money; therefore, interest rates will (increase or decline)

Corporations decrease their demand for funds following a decrease in investment opportunities.

This action will cause interest rates to (increase decrease)

The government runs a larger-than-expected budget deficit.

The larger the federal deficit, other things held constant, the (higher lower) the level of interest rates.

There is a decrease in expected inflation.

This expectation will cause interest rates to (increase or decrease)

.

b. Suppose you are considering two possible investment opportunities: a 12-year Treasury bond and a 7-year, AA-rated corporate bond. The current real risk-free rate is 5%, and inflation is expected to be 3% for the next 2 years, 4% for the following 4 years, and 5% thereafter. The maturity risk premium is estimated by this formula: MRP = 0.03(t - 1)%. The liquidity premium (LP) for the corporate bond is estimated to be 0.2%. You may determine the default risk premium (DRP), given the company's bond rating, from the following table. Remember to subtract the bond's LP from the corporate spread given in the table to arrive at the bond's DRP.

			Corporate Bond Yield
	Rate		Spread = DRP + LP
U.S. Treasury	0.73	%
AAA corporate	0.93		0.20	%
AA corporate	1.35		0.62
A corporate	1.71		0.98

What yield would you predict for each of these two investments? Round your answers to three decimal places.

12-year Treasury yield: ______%

7-year Corporate yield: ______%