(5-20)

Because of a recession, the inflation rate expected for the coming year is only 3%. However, the
inflation rate in year 2 and thereafter is expected to be constant at some level above 3%. Assume
that the real risk free rate is r* = 2% for all maturities and that there are no maturity premiums. If
3-year Treasury notes yield 2 percentage point more than 1-year notes, what inflations rate is
expected after year 1 ?

Answer :
Basic relevant equations :
Rt = r* + IPt + DRPt + MRPt + LPt-
But here IP is the only premium, so rt = r* + IPt-
IPt- = Avg. Inflation = (I1 + I2 + . . .)/N
We know that I1 =IP1 = 3 % and r* = 2%. Therefore,
r1 = 2% + 3% = 5%. r3 =r1 + 2% = 5% + 2% = 7%.
r3 = r* + IP3 = 2% = 5%
We also know that It = Constant after t=1.

r* I Avg.I =IPt r = r* + IPt

1 2 3 3%/1 =3% 5%
2 2 I (3%+I)/2=IP2
3 2 I (3%+I+I)/3=IP3 r3 = 7%, jadi IP3 = 7% - 2% = 5%

Avg.I = IP3 = (3%+2I)/3 = 5%

2I = 12 %
I=6%