In late 1980 , the U.S. Commerce Department released new data showing infiation was 15%. At the time, the prime rate of linterest was 21%, a record high. However, many investors expected the new Reagan administration to be more effective in controlting inflation than the Carter administration had been. Moreover, many observers believed that the extremely high interest rates and generally tight credit, which resulted from the Federal Reserve System's attempts to curb the inflation rate, would lead to a recession, which, in turn, would lead to a decline in inflation and interest rates, Assume that at the beginning of 1981, the expected inflation rate for 1981 was 14%; for 1982,9%; for 1983,7%; and for 1984 and thereafter, 6%. a. What was the average expected infiation rate over the 5 -year period 1981 - 1985 ? (Use the arithmetic ayerage.) Round your answer to two decimal blaces. ol b. Over the 5-year period, what average nominal interest rate would be expected to produce a 1% real risk-free return on 5 -year Treasury securitles? Assume MRP = 0. Round your answer to two decimal places. c. Assuming a real risk-free rate of 1% and a maturity risk premium that equals 0.1(t)%, where t is the number of years to maturity, estimate the interest rate in January 1981 on bonds that mature in 1,2,5,10 and 20 years. Round your answers to two decimal places. Select the correct yield curve based on these data. Describe the oeneral economic conditions that could lead to an upward sloping yinid curve. 1. An upward sloping yield curve is indicative of a period where inflition is mpected to increase, and since the MrP increases with years, the yield curve slopes up. During a recessfon, the vield curve typicafliflopos upward, because inflation and consequently short-term interest rates are currently low, yet people expect inflation and intenest rafes to rise as the economy comes out of the recession. 11. An upward sloping yield curve is indicative of a period where inflation ly not expected to trend either up or down, but since the MrP increases with years, the yield curve slopes up. During a recession, the yeed curve typically sfopes up steeply, because inflation and consequently short-term interest rates are currently low, yet people expect inflation and interest rates to rise as the economy comes out of the recession. III. An upward sloping yield curve is indicative of a period where inflation is expected to decsease, but since the Mrp increases with years, the yield curve slopes up. During a recession, the yinld curve typically slopes up steeply, because intlation and consequently thort-term interest rates are currenty nigh, yet people expect inflation and interest rates to fall as the economy comes out of the recession. IV. An upward sloping vield curve is indicative of a period where inflation is expected to decrease, but aince the Mep decreases with vears, the viold curve. slopes up. Durine a recession, the yield curve tvpically flopes downward, becaule inflation and conseguentiy bhort-term interest rates are currently hioh, vet people expect inflation and interest rates to fail as the economy comes out of the recession. V. An upward soping vield curve is indicative of a period where inflation is not expected to trend elther up or down, but since the MrP. increasos with years, the yeld curve slopes up. During a recession, the yield curve typically slopes up steeply. because intlation and consequenty short-term interest rates are currently high, yet people expect inflation and interest rates to fall as the economy comes out of the recesston. e. If imvestors in early 1981 expected the inflation rate for every future year to be 10% (i.e., Ig=It+1=100 for t1 to oo), what would the yield curve have looked like? Consider all the factors that are likely to. affect the curve. Docs your answer hiere make you question the yield curve you drew in part c? 1. If inflation rates are expected to be constant, then the expectations theory holds that the yield curve should be horizontal. However, in this event it is likely that maturity risk premiums would be applied to long-term bonds because of the greater risks of holding longterm rather than short-term bonds. Therefore, the yield curve would be more nearfy normal; that is, the long-term end of the curve would be raised. 11. If inflation rates are expected to be constant, then the expectations theory holds that the yield curve should be vertical. However, in this event it is likely that maturity risk premiurns would be applied to fong-term bonds because of the greater risks of holding longterm rather than short-term bonds. Therefore, the yield curve would be more nearly normali; that is, the long-term end of the curve would be sloped to the right. III. If inflation rates are expected to be constant, then the expectations theofy holds that the yield curve should be horizontal. However, in this event it is likely that maturity risk premiums would be applied to long-term bonds because of the lower risks of holding longterm rather than short-term bonds. Therefore, the yield curve would be more nearly normal; that is, the long-term end of the curve would be raised. IV. If inflation rates are expected to be constant, then the expectations theory holds that the yield curve should be upward sloping. However, in this event it is likely that maturity risk premiums would not be applied to long term bonds because of the lower risks of holding long-terin rather than short-term bonds. Therefore, the vield curve would be more nearly normal; that is, the fong-term end of the curve would be horizontal. In late 1980 , the U.S. Commerce Department released new data showing infiation was 15%. At the time, the prime rate of linterest was 21%, a record high. However, many investors expected the new Reagan administration to be more effective in controlting inflation than the Carter administration had been. Moreover, many observers believed that the extremely high interest rates and generally tight credit, which resulted from the Federal Reserve System's attempts to curb the inflation rate, would lead to a recession, which, in turn, would lead to a decline in inflation and interest rates, Assume that at the beginning of 1981, the expected inflation rate for 1981 was 14%; for 1982,9%; for 1983,7%; and for 1984 and thereafter, 6%. a. What was the average expected infiation rate over the 5 -year period 1981 - 1985 ? (Use the arithmetic ayerage.) Round your answer to two decimal blaces. ol b. Over the 5-year period, what average nominal interest rate would be expected to produce a 1% real risk-free return on 5 -year Treasury securitles? Assume MRP = 0. Round your answer to two decimal places. c. Assuming a real risk-free rate of 1% and a maturity risk premium that equals 0.1(t)%, where t is the number of years to maturity, estimate the interest rate in January 1981 on bonds that mature in 1,2,5,10 and 20 years. Round your answers to two decimal places. Select the correct yield curve based on these data. Describe the oeneral economic conditions that could lead to an upward sloping yinid curve. 1. An upward sloping yield curve is indicative of a period where inflition is mpected to increase, and since the MrP increases with years, the yield curve slopes up. During a recessfon, the vield curve typicafliflopos upward, because inflation and consequently short-term interest rates are currently low, yet people expect inflation and intenest rafes to rise as the economy comes out of the recession. 11. An upward sloping yield curve is indicative of a period where inflation ly not expected to trend either up or down, but since the MrP increases with years, the yield curve slopes up. During a recession, the yeed curve typically sfopes up steeply, because inflation and consequently short-term interest rates are currently low, yet people expect inflation and interest rates to rise as the economy comes out of the recession. III. An upward sloping yield curve is indicative of a period where inflation is expected to decsease, but since the Mrp increases with years, the yield curve slopes up. During a recession, the yinld curve typically slopes up steeply, because intlation and consequently thort-term interest rates are currenty nigh, yet people expect inflation and interest rates to fall as the economy comes out of the recession. IV. An upward sloping vield curve is indicative of a period where inflation is expected to decrease, but aince the Mep decreases with vears, the viold curve. slopes up. Durine a recession, the yield curve tvpically flopes downward, becaule inflation and conseguentiy bhort-term interest rates are currently hioh, vet people expect inflation and interest rates to fail as the economy comes out of the recession. V. An upward soping vield curve is indicative of a period where inflation is not expected to trend elther up or down, but since the MrP. increasos with years, the yeld curve slopes up. During a recession, the yield curve typically slopes up steeply. because intlation and consequenty short-term interest rates are currently high, yet people expect inflation and interest rates to fall as the economy comes out of the recesston. e. If imvestors in early 1981 expected the inflation rate for every future year to be 10% (i.e., Ig=It+1=100 for t1 to oo), what would the yield curve have looked like? Consider all the factors that are likely to. affect the curve. Docs your answer hiere make you question the yield curve you drew in part c? 1. If inflation rates are expected to be constant, then the expectations theory holds that the yield curve should be horizontal. However, in this event it is likely that maturity risk premiums would be applied to long-term bonds because of the greater risks of holding longterm rather than short-term bonds. Therefore, the yield curve would be more nearfy normal; that is, the long-term end of the curve would be raised. 11. If inflation rates are expected to be constant, then the expectations theory holds that the yield curve should be vertical. However, in this event it is likely that maturity risk premiurns would be applied to fong-term bonds because of the greater risks of holding longterm rather than short-term bonds. Therefore, the yield curve would be more nearly normali; that is, the long-term end of the curve would be sloped to the right. III. If inflation rates are expected to be constant, then the expectations theofy holds that the yield curve should be horizontal. However, in this event it is likely that maturity risk premiums would be applied to long-term bonds because of the lower risks of holding longterm rather than short-term bonds. Therefore, the yield curve would be more nearly normal; that is, the long-term end of the curve would be raised. IV. If inflation rates are expected to be constant, then the expectations theory holds that the yield curve should be upward sloping. However, in this event it is likely that maturity risk premiums would not be applied to long term bonds because of the lower risks of holding long-terin rather than short-term bonds. Therefore, the vield curve would be more nearly normal; that is, the fong-term end of the curve would be horizontal