INFLATION AND INTEREST RATES In late 1980, the U.S. Commerce Department released new data showing inflation was 15%. At the time, the prime rate of interest was 21%, a record high. However, many investors expected the new Reagan administration to be more effective in controlling 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 Systems 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 13%; for 1982, 9%; for 1983, 7%; and for 1984 and thereafter, 6%.

a. What was the average expected inflation rate over the 5-year period 19811985? (Use the arithmetic average.)

b. Over the 5-year period, what average nominal interest rate would be expected to produce a 2% real risk-free return on 5-year Treasury securities? Assume MRP 0.

c. Assuming a real risk-free rate of 2% 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. Draw a yield curve based on these data.

d. Describe the general economic conditions that could lead to a upward sloping yield curve.

e. If investors in early 1981 expected the inflation rate for every future year to be 10%

(i.e., It It 1 10% for t 1 to , what would the yield curve have looked like? Consider all the factors that are likely to affect the curve. Does your answer here make you question the yield curve you drew in part c?