Assuming that the expectations theory is the correct theory of the term structure, calculate the interest rates in the term structure for maturities of 1 to 5 years and plot the resulting yield curves for the following series of 1-year interest rates over the next 5 years:

(a) 5%, 7%, 7%, 7%, 7%

(b) 5%, 4%, 4%, 4%, 4%

1. How would your yield curves change if people preferred shorter-term bonds over longer-term bonds?

2. Considering the shape of yield curves for 1 and 2 what is the market predicting about future short-term interest rates? Note: Figure of yield curve is required.

3. What might the yield curve indicate about the inflation rate in the future?