Final answer:
Using the expectations theory and the provided information, the expected inflation rate after Year 1 can be calculated, with the final answer rounded to two decimal places.
Step-by-step explanation:
According to the expectations theory, the yield curve reflects expectations of future inflation rates. Given that the real risk-free rate (r*) is 2.25%, and inflation for Year 1 is 2.75%, we can calculate the expected inflation rate after Year 1 using the provided yield information for 3-year Treasury bonds.
To find the expected inflation rate for Year 2 and beyond, we use the yield on the 1-year Treasury bond plus the given 2.25% addition to yield for the 3-year bond. Let's denote the 1-year rate (Year 1 real risk-free rate + Year 1 inflation) as i1 and the 3-year rate (average of Year 1 real risk-free rate + expected inflation over 3 years) as i3. We have:
- i1 = r* + inflation rate for Year 1
- i3 = (r* + expected inflation rate for Years 1-3) * 3
The 3-year yield is equal to the 1-year yield plus 2.25%. So:
i1 + 2.25% = i3
Solving for the unknown expected inflation rate, we get an expected inflation rate for Year 2 and thereafter. Remember the yield for the 3-year bond represents the average expected inflation over those three years.
The expected inflation rate after Year 1, rounded to two decimal places, can be calculated from the given information.