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What effect would each of the following events likely have on the level of nominal interest rates?

Households dramatically increase their savings rate.

This action will

increasedecrease

1. the supply of money; therefore, interest rates will.

Corporations increase their demand for funds following an increase in investment opportunities.

This action will cause interest rates to

increasedecrease

1. .

The government runs a smaller-than-expected budget deficit.

The smaller the federal deficit, other things held constant, the

higherlower

1. the level of interest rates.

There is an increase in expected inflation.

This expectation will cause interest rates to

increasedecrease

1. .

increasedecline

Suppose you are considering two possible investment opportunities: a 12-year Treasury bond and a 7-year, AA-rated corporate bond. The current real risk-free rate is 3%, and inflation is expected to be 2% for the next 2 years, 3% for the following 4 years, and 4% thereafter. The maturity risk premium is estimated by this formula: MRP = 0.01(t - 1)%. The liquidity premium (LP) for the corporate bond is estimated to be 0.2%. You may determine the default risk premium (DRP), given the company's bond rating, from the following table. Remember to subtract the bond's LP from the corporate spread given in the table to arrive at the bond's DRP.

		Corporate Bond Yield
	Rate	Spread = DRP + LP
U.S. Treasury	0.73	%
AAA corporate	0.83		0.10	%
AA corporate	1.21		0.48
A corporate	1.61		0.88

What yield would you predict for each of these two investments? Round your answers to three decimal places.

12-year Treasury yield: fill in the blank 7 %

7-year Corporate yield: fill in the blank 8 %

Given the following Treasury bond yield information, construct a graph of the yield curve.

Maturity	Yield
1 year	5.42	%
2 years	5.47
3 years	5.69
4 years	5.73
5 years	5.67
10 years	5.75
20 years	6.25
30 years	5.92

Choose the correct graph.

The correct graph is

graph Agraph Bgraph Cgraph D

• .

A.		B.
C.		D.

Based on the information about the corporate bond provided in part b, calculate yields and then construct a new yield curve graph that shows both the Treasury and the corporate bonds. Round your answers to two decimal places.

Years	Treasury yield	AA-corporate yield
1		5.42	%	fill in the blank 10 %
2		5.47	%	fill in the blank 11 %
3		5.69	%	fill in the blank 12 %
4		5.73	%	fill in the blank 13 %
5		5.67	%	fill in the blank 14 %
10		5.75	%	fill in the blank 15 %
20		6.25	%	fill in the blank 16 %
30		5.92	%	fill in the blank 17 %

Choose the correct graph.

The correct graph is

graph Agraph Bgraph Cgraph D

• .

A.		B.
C.		D.

Which part of the yield curve (the left side or right side) is likely to be most volatile over time?

Short-term rates are

moreless

• volatile than longer-term rates; therefore, theside of the yield curve would be most volatile over time.

leftright

Using the Treasury yield information in part c, calculate the following rates using geometric averages (round your answers to three decimal places):

The 1-year rate, 1 year from now

fill in the blank 21 %

The 5-year rate, 5 years from now

fill in the blank 22 %

The 10-year rate, 10 years from now

fill in the blank 23 %

The 10-year rate, 20 years from now

fill in the blank 24 %