Final answer:
The expectations hypothesis states that investors expect 1.higher long-term interest rates today if they anticipate higher inflation rates in the future, which impacts the yield curve for bonds. Monitoring inflation expectations is crucial for informing monetary policy and investment decisions.
Step-by-step explanation:
The expectations hypothesis states that the shape of the yield curve reflects the market’s expectations for future short-term interest rates. When investors expect rising inflation in the future, they will generally require higher long-term interest rates today (option 1). This is because inflation erodes the purchasing power of money, and investors want to be compensated for the anticipated decline in real value. Hence, when expected inflation increases, nominal interest rates, which include the real rate and expected inflation factor, also go up.
Expected inflation is important because it influences how the public perceives the economy's direction. An increase in expected inflation might signal a booming economy or supply shocks, leading to different monetary policy actions by the central bank. Conversely, a decrease in expected inflation might signal an impending recession and the potential for expansionary monetary policy. These expectations affect decisions on major purchases like houses and cars and the nominal interest rates attached to loans for these large investments.
The expectations hypothesis thus helps in understanding why and how inflation expectations are crucial for monetary policy and investment decisions. It is essential for economists to measure expectations to assess macroeconomic policy's effectiveness, project the direction of real interest rates, and make informed financing decisions.