Task: Suppose the annual yield on a 2-year Treasury bond is 4.5%, while that on a 1-year bond is 3%. k* (=real risk-free rate of interest) is 1 percent, and the maturity risk premium is zero.
Q1. Using the expectations theory, forecast the interest rate on a 1-year bond during the second year. (Hint: Under the expectations theory, the yield on a 2-year bond is equal to the average yield on 1-year bonds in years 1 and 2.)
Q2. What is the expected inflation rate in Year 1 and Year 2?