Assume that it is now 3^rdJanuary, 2010. The rate of inflation is expected to be 6 percent throughout 2010. 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 7 percent in 2011, 8 percent in 2012, 9 percent in 2013 and 11 percent in 2014. The real risk-free rate, k*, is expected to remain at 4 percent over the next 6 years. Assume that no maturity risk premiums are required on bonds with 5 years or less to maturity. The current interest rate on 6-year T-bonds is 12 percent.

Required:

1. What is the average expected inflation rate over the next 5 years?
2. What should be the prevailing interest rate on 5-year T-bonds?
3. What is the implied expected inflation rate in 2015, or Year 6, given that Treasury bonds which mature in that year yield 12 percent?