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Economics 330 – Money and Banking
Spring 2010
Dr. Neri
Problem Set 3 – Due within the first 5 minutes of lecture on Wednesday October 13, 2010. Late
submissions and Email submissions will not be accepted. You must show your calculations.
Question No. 1
Assume the Expectations Theory is correct. This question uses the notation presented in class for the
Expectations Theory and listed on the PowerPoint lecture slides. Remember t is today (0), the beginning
of year one, t+1 is (1), oneyear from now at the beginning of year 2, etc.
Suppose I know the real interest rate on a oneyear bond starting now is 2% (r
1,t
= 2%)
and inflation
today is expected to be 2% (
1
2 %
e
t
).
I expect
r
1, t+1
= 2% and
1
1
3 %
e
t
and
r
1, t+2
= 2%
and
1
2
4 %
e
t
. This says the real interest rate on a oneyear bond is currently 2% and it is
expected to remain constant over the following two years (years 2 and 3). The expected rate of inflation
in year one is 2% and it is expected to increase to 3% and 4% over the following two years, respectively.
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This note was uploaded on 11/30/2010 for the course ECON 0101 taught by Professor Johnneri during the Spring '08 term at Maryland.
 Spring '08
 JohnNeri

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