A recent study of inflationary 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; that is, 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

a. If the real rate of interest is currently 2.5%, find the nominal rate of interest on each of the following U.S. Treasury issues: 20-year bond, 3-month bill, 2-year note, and 5-year bond.

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

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

d. What would a follower of the liquidity preference theory say about how the preferences of lenders and borrowers tend to affect the shape of the yield curve drawn in part c? Illustrate that effect by placing on your graph a dotted line that approximates the yield curve without the effect of liquidity preference.

e. What would a follower of the market segmentation theory say about the supply and demand for long-term loans versus the supply and demand for short-term loans given the yield curve constructed for part c of this problem?