This question is related to the concept of forward guidance by a Central Bank (CB). Suppose that the interest rates on one-year, two-year and three-year bonds are 3.96%, 3.80% and 3.73%, respectively. For simplicity, assume that the Pure Expectations Theory holds strictly.

a) (5 points) Now suppose the CB announces that it is concerned about signs of increasing inflation and states that is plans to have to start raising short-term rates starting next year. Specifically, the CB announces it plans to take action to increase the one-year bond rate to 4.00% next year and to 5.00% the following year. Suppose further that the market believes the CB. Calculate what would happen to the current two-year and three-year spot rates right now. What is the CB trying to achieve? b) (3 points) Describe the importance of CB credibility in this situation. That is, what would happen if the market did not believe the CBs announcement?