Final answer:
Cautious bondholders should expect interest rates to rise and move to the short-end of the yield curve as inflation is expected to increase significantly. In the context of government debt and mortgages, a rise in inflation benefits borrowers like the state government, and a fall in inflation potentially benefits homeowners with adjustable-rate mortgages.
Step-by-step explanation:
If inflation is expected to increase significantly, cautious bondholders should expect interest rates to rise, as inflation usually leads to higher interest rates. In this scenario, they should not expect a flat yield curve for the intermediate-term, as inflation can steepen the yield curve due to expectations of higher future rates. Buying long-term bonds today would not be advisable, because the value of these bonds would decrease as interest rates rise. Therefore, cautious bondholders should move to the short-end of the yield curve to avoid significant losses in bond value if interest rates increase.
Regarding the additional questions, if inflation rises unexpectedly by 5%, a state government that had recently borrowed money to pay for a new highway would benefit, as it would pay back the debt with money that is less valuable than when it was borrowed. An increase in inflation typically causes the interest rate on an adjustable-rate mortgage to rise, as this type of loan adjusts according to market rates. Conversely, if inflation falls unexpectedly by 3%, a homeowner with an adjustable-rate mortgage would likely benefit from a lower interest rate on their loan payments.