Nominal Interest Rates and Yield Curves: A recent study of inflation expectations has revealed that the consensus among economic forecasters yields the following average annual rates of inflation expected over the periods noted. (Note: Assume that the risk that future interest rate movements will affect longer maturities more than shorter maturities is zero; i.e. assume that there is no maturity risk.)

Average annual

Period rate of inflation

3 months 5%

2 years 6%

5 years 8%

10 years 8.5%

20 years 9%

If the real rate of interest is currently 2.5%, find the nominal rate of interest on the 20-year bond, the 3-month bill, 2-year note and the 5-year note.

If the real rate of interest suddenly dropped to 2% without any change in inflation expectations, what effect, if any, would it have on your answers in Part a? Explain.

Using your findings in part a, draw the yield curve for U.S. Treasuries. Describe the general shape and expectations reflected by the curve.