Inflation and Interest Rates In late 1980, the U.S. Commerce Department released
ID: 2730217 • Letter: I
Question
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 System's 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, 10%; for 1983, 7%; and for 1984 and thereafter, 6%.
What was the average expected inflation rate over the 5-year period 1981 - 1985? Round your answer to two decimal places. (Use the arithmetic average.)
%
Over the 5-year period 1981 - 1985, what average nominal interest rate would be expected to produce a 3% real risk-free return on 5-year Treasury securities? Assume MRP = 0. Round your answer to two decimal places.
%
Assuming a real risk-free rate of 1% 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 year. Round your answer to two decimal places.
%
Assuming a real risk-free rate of 1% 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 2 years. Round your answer to two decimal places.
%
Assuming a real risk-free rate of 1% 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 3 years. Round your answer to two decimal places.
%
Assuming a real risk-free rate of 1% 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 5 years. Round your answer to two decimal places.
%
Assuming a real risk-free rate of 1% 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 10 years. Round your answer to two decimal places.
%
Assuming a real risk-free rate of 1% 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 20 years. Round your answer to two decimal places.
%
The correct sketch is ???
Describe the general economic conditions that could lead to an upward-sloping yield curve.
-Select-
a. An upward sloping yield curve is indicative of a period where inflation is expected to decrease, but since the MRP increases with years, the yield curve slopes up. During a recession, the yield curve typically slopes up steeply, because inflation and consequently short-term interest rates are currently high, yet people expect inflation and interest rates to fall as the economy comes out of the recession.
b. An upward sloping yield curve is indicative of a period where inflation is expected to decrease, but since the MRP decreases with years, the yield curve slopes up. During a recession, the yield curve typically slopes downward, because inflation and consequently short-term interest rates are currently high, yet people expect inflation and interest rates to fall as the economy comes out of the recession.
c. An upward sloping yield curve is indicative of a period where inflation is not expected to trend either up or down, but since the MRP increases with years, the yield curve slopes up. During a recession, the yield curve typically slopes up steeply, because inflation and consequently short-term interest rates are currently high, yet people expect inflation and interest rates to fall as the economy comes out of the recession.
d. An upward sloping yield curve is indicative of a period where inflation is expected to increase, and since the MRP increases with years, the yield curve slopes up. During a recession, the yield curve typically slopes upward, because inflation and consequently short-term interest rates are currently low, yet people expect inflation and interest rates to rise as the economy comes out of the recession.
e. An upward sloping yield curve is indicative of a period where inflation is not expected to trend either up or down, but since the MRP increases with years, the yield curve slopes up. During a recession, the yield curve typically slopes up steeply, because inflation and consequently short-term interest rates are currently low, yet people expect inflation and interest rates to rise as the economy comes out of the recession.
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 System's 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, 10%; for 1983, 7%; and for 1984 and thereafter, 6%.
What was the average expected inflation rate over the 5-year period 1981 - 1985? Round your answer to two decimal places. (Use the arithmetic average.)
%
Over the 5-year period 1981 - 1985, what average nominal interest rate would be expected to produce a 3% real risk-free return on 5-year Treasury securities? Assume MRP = 0. Round your answer to two decimal places.
%
Assuming a real risk-free rate of 1% 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 year. Round your answer to two decimal places.
%
Assuming a real risk-free rate of 1% 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 2 years. Round your answer to two decimal places.
%
Assuming a real risk-free rate of 1% 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 3 years. Round your answer to two decimal places.
%
Assuming a real risk-free rate of 1% 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 5 years. Round your answer to two decimal places.
%
Assuming a real risk-free rate of 1% 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 10 years. Round your answer to two decimal places.
%
Assuming a real risk-free rate of 1% 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 20 years. Round your answer to two decimal places.
%
The correct sketch is ???
Describe the general economic conditions that could lead to an upward-sloping yield curve.
-Select-
a. An upward sloping yield curve is indicative of a period where inflation is expected to decrease, but since the MRP increases with years, the yield curve slopes up. During a recession, the yield curve typically slopes up steeply, because inflation and consequently short-term interest rates are currently high, yet people expect inflation and interest rates to fall as the economy comes out of the recession.
b. An upward sloping yield curve is indicative of a period where inflation is expected to decrease, but since the MRP decreases with years, the yield curve slopes up. During a recession, the yield curve typically slopes downward, because inflation and consequently short-term interest rates are currently high, yet people expect inflation and interest rates to fall as the economy comes out of the recession.
c. An upward sloping yield curve is indicative of a period where inflation is not expected to trend either up or down, but since the MRP increases with years, the yield curve slopes up. During a recession, the yield curve typically slopes up steeply, because inflation and consequently short-term interest rates are currently high, yet people expect inflation and interest rates to fall as the economy comes out of the recession.
d. An upward sloping yield curve is indicative of a period where inflation is expected to increase, and since the MRP increases with years, the yield curve slopes up. During a recession, the yield curve typically slopes upward, because inflation and consequently short-term interest rates are currently low, yet people expect inflation and interest rates to rise as the economy comes out of the recession.
e. An upward sloping yield curve is indicative of a period where inflation is not expected to trend either up or down, but since the MRP increases with years, the yield curve slopes up. During a recession, the yield curve typically slopes up steeply, because inflation and consequently short-term interest rates are currently low, yet people expect inflation and interest rates to rise as the economy comes out of the recession.
Explanation / Answer
Question 1:
Average inflation = sum of inflation/ no. of years
= (13%+10%+7%+6%+6%)/5
=42%/5
= 8.40%
Question 2:
Nominal return = real risk free return + average inflation + MRP
= 3%+ 8.40% + 0
= 11.40%
Question 3:
Nominal return = real risk free return + average inflation + MRP
= 1% + 13% +0.01 x (1) %
= 14.01%
Question 4:
Nominal return = real risk free return + average inflation + MRP
= 1% + (13%+10%)/2 +0.01 x (1) %
= 12.51%