Suppose the current one-year interest rate is 6%. One year from now, you believe the economy will start to slow and the one-year interest rate will fall to 5%. In two years, you expect the economy to be in the midst of a recession, causing the Federal Reserve to cut interest rates drastically and the one-year interest rate to fall to 2%. The one-year interest rate will then rise to 3% the following year, and continue to rise by 1% per year until it returns to 6%, where it will remain from then on.
a. If you were certain regarding these future interest rate changes, what two-year interest rate would be consistent with these expectations?
b. What current term structure of interest rates, for terms of 1 to 10 years, would be consistent with these expectations?
c. Plot the yield curve in this case. How does the one-year interest rate compare to the 10-year interest rate?