Assume that the rate of inflation is expected to be 2 percent during the next 12 months (Year 1). The

following year and thereafter, increased government deficits and renewed vigor in the economy are

expected to push inflation rates higher. Investors expect the inflation rate to be 3 percent the year after

this coming year (in Year 2), 5 percent in the year after that (in Year 3), and 6 percent in the year that

follows (in Year 3). The real risk-free rate, r*, currently is 3 percent. Assume that no maturity risk

premiums are required on bonds with five years or less to maturity. The current interest rate on five-year

T-bonds is 11 percent.

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

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

c. What is the implied expected inflation rate in Year 5, given that bonds that mature in Year 5 yield 11

percent?