) Inflation rate is expected to be 7 percent next year, then fall to 5 percent during the following year, and then to remain at a rate of 3 percent thereafter. Given that the real risk-free rate, k*, will remain at 2 percent and that MRPs on Treasury securities rise from 0% on very short-term bonds (those that mature in a few days) to a level of 0.2% for 1-year bonds. Furthermore, MRPs increase 0.2% for each year to maturity, up to a maximum limit of 1% on 5-years or longer-term Treasury bonds.

a) Calculate the interest rate on 1, 2, 3, 10 and 20-year Treasury securities. (5 marks)

b) Do the interest rates reflect an upward or downward sloping yield curve? What does that tell about the state of the economy? (2 marks)