1) A) Suppose that several months of data showed the CPI increasing at a 4.5% annual rate due largely to increases in the price of energy and food related commodities following several years when the CPI only increased by 1% per year. Suppose this increase causes investor expectations of annual inflation to also increase from 1% to 4.5%. Assume, at the same time that fears of higher inflation creates concerns that rising interest rates will derail the economic recovery and lead to another recession. Assume the resulting increase in risk aversion among investors drives the expected real rate of return required to equate investor demand to the existing supply of 1 year Treasury notes down to 0.5 % from 2%. What would you expect to happen to the nominal yields on 1-year T-notes during the period over which these changes in inflation expectations and required real yields occurred? (Give a numerical answer if possible) Explain your reasoning.
B) Draw a supply/demand diagram of the US Treasury bond market to illustrate the effects on it of the developments cited in part A. (Note: you do not have to include the exact numerical price before and after the change in expectations.) Label your diagram clearly!