1) Explain using the diagrams for bonds markets why does the risk premium (spread) becomes bigger during recessions?

2) If the interest rate on a brand-new one-year bond is 4% and people expect the one-year bond rate to rise to 5% next year, 6% the year after, 7% the year after that, and 8% the year after that, then: * the interest rate on a 1-year bond sold today is ____

* What will the interest rates on 2-, 3-, 4-, and 5-year bonds be based on the expectations hypothesis. Draw the yield curve for these set of bonds.

3) Suppose that the current i on 1-year bonds is 2% and the expected interest rate on all one-year bonds to be issued in the next five years is also 2%. Suppose that the illiquidity premium is:

ln,t = (0.1)(n-1) (%)

What will the interest rates on 2-, 3-, 4-, and 5-year bonds:

a. be based on the expectations hypothesis of term structure of interest rates?

b. based on the liquidity-premium theory?

Draw the yield curve for both part a and b.

4) Based on the YC for question 3 part b, forecast what do you expect about future Real GDP and inflation over the next 5 years. How would you evaluate the stance of current monetary policy?