A) Suppose that as the economic recovery strengthened consumer expectations of annual inflation increased from 2% to 3.5 % and, at the same time, the expected real rate of return required to equate investor demand to the existing supply of 1 year Treasury notes increased from 1% to 1.5%. What would you expect to happen to the nominal yields on 1-year T-notes during the period over which these changes in inflation expectations and required real yields occurred? (Give a numerical answer if possible) Explain your reasoning.
To determine the expected change in nominal yields on 1-year Treasury notes, we need to consider the impact of the changes in inflation expectations and the required real rate of return.
Nominal yield is the sum of the expected inflation rate and the required real rate of return. Mathematically, it can be represented as:
Nominal Yield = Expected Inflation Rate + Required Real Rate of Return
Initially, the inflation expectation was 2% and the required real rate of return was 1%. This means the nominal yield was:
Nominal Yield = 2% + 1% = 3%
After the changes, the inflation expectation increased to 3.5% and the required real rate of return increased to 1.5%. The new nominal yield can be calculated as:
Nominal Yield = 3.5% + 1.5% = 5%
Given these changes, we can expect the nominal yields on 1-year Treasury notes to increase from 3% to 5% during the period over which these changes occurred.
The reasoning behind this expectation is that as inflation expectations increase, investors demand a higher nominal yield to compensate for the higher expected erosion of purchasing power due to inflation. Similarly, as the required real rate of return increases, investors would also demand a higher nominal yield to offset the higher risk or opportunity cost of investing in these Treasury notes.
Therefore, the combined effect of higher inflation expectations and a higher required real rate of return would lead to an increase in the nominal yields on 1-year Treasury notes.