Question

Economic forecasters predict that the rate of inflation will hold steady at 2.5% per year indefinitely.

The table shows the nominal interest rate paid on the securities having different maturities.

Maturity Nominal rate of return

3 month 5.5%

2 years 6%

5 years 8%

10 years 9%

20 years 10.5%

A. Approximately what real interest rate paid on the securities having different maturities

B. If the nominal rate of interest paid by every Treasury security suddenly dropped to 1.5% without any change in inflationary expectations, what effect, if any would this have on answers in part a?

C. Using the findings in part a select the appropriate 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 in part c?

E. What would a follower of the market segmentation say about the supply and demand for long term loans versus the supply and demand for short term loans given the yield curve in part c?

Answer 1

d. Real date op huwu i nominal Nominal A Real rati of rellurn = interest) - 1 (at nominal It Roll oy rate of Inflation 3 month = 2 years panta 5 years = 1.055 -1 2.9.3 % 0.025 1.06. - = 3.911, 1.025 1.08 -| ___5.3.7% 1.025 1.09 L =_ 6.34% 1.025 1.105 - = 7.80 % 1025 10 years = -20 years = of reltern in In each that case 11.015 1.025 case would - real rate equel to - 0.98% = ____1.5. Treasury securities indicate a normal yield wree with visig interest rates with lonper duration Normal yield carve denotes that interest rates will rise with The longetivity of the duration of securitics... Scanned with CamScanner

D According to the liquidity Preference Theory the intest rates should use with increase in the duration of securities Hence a follower of liquidity preference theory would always accept the normal Yield curve porta Diagram of Lield curve. maturity. Interest Rates . Scanned with CamScaniter