Question 1

According to the expectations theory, if next year's expected short-term rate is below the current short-term rate,&#10;A) the current long-term rate will be below the current short-term rate.&#10;B) the current long-term rate will be above the current long-term rate.&#10;C) the current long-term rate will be horizontal.&#10;D) the current long-term rate will be vertical.

Accepted Answer

The expectations theory suggests that long-term interest rates are an average of current and expected future short-term interest rates. If next year's expected short-term rate is below the current short-term rate, it implies that the average (and thus the current long-term rate) will be lower than the current short-term rate, supporting choice A.

Question 2

&#10;&#10;-According to expectations theory, which of the figures above reflects expectations of a rise in the interest rate on short-term securities?&#10;A) Figure A&#10;B) Figure B&#10;C) Figure C&#10;D) Both a and b

Accepted Answer

Expectations theory suggests that if investors expect short-term interest rates to rise, the yield curve will slope upwards, as shown in Figure A.

Question 3

&#10;&#10;-Refer to Figures A, B, and C. According to expectations theory, which of the figures above reflects expectations of a fall in the interest rate on short-term securities?&#10;A) Figure A&#10;B) Figure B&#10;C) Figure C&#10;D) Both a and b

Accepted Answer

Expectations theory suggests that if investors expect future short-term interest rates to fall, the yield curve will be downward sloping, as investors will demand less yield for longer-term securities, anticipating lower rates in the future. Figure C, with a downward-sloping yield curve, reflects this expectation.

Question 4

&#10;&#10;-Refer to Figures A, B, and C. According to expectations theory, which of the figures is most likely to be associated with expected growth in income, expected increases in prices, and slower growth of money supply?&#10;A) Figure A&#10;B) Figure B&#10;C) Figure C&#10;D) Both a and b

Accepted Answer

According to expectations theory, an upward-sloping yield curve (as in Figure A) is typically associated with expectations of future economic growth, rising income, and inflation, which can occur alongside a slower growth of the money supply.

Question 5

&#10;&#10;-Refer to Figures A, B, and C. According to expectations theory, which of the figures reflects expectations that the short-term interest rate is expected to remain constant in the future but that borrowers and lenders also must be compensated with a liquidity premium for lending long?&#10;A) Figure A&#10;B) Figure B&#10;C) Figure C&#10;D) Both a and b

Accepted Answer

Figure A reflects expectations that the short-term interest rate is expected to remain constant in the future but includes an upward slope to account for the liquidity premium required by lenders for longer-term loans. This is consistent with the expectations theory, which suggests that the shape of the yield curve reflects expectations of future interest rates, with adjustments for premiums such as liquidity.

Question 6

&#10;&#10;-Refer to Figures A, B, and C. According to expectations theory, which of the figures best reflects a situation where i?>i???&#10;A) Figure A&#10;B) Figure B&#10;C) Figure C&#10;D) None of the above

Accepted Answer

Expectations theory states that the yield curve reflects the market's expectations of future short-term interest rates. In Figure C, the yield curve is upward sloping, which means that the market expects short-term interest rates to increase in the future. This is consistent with the situation where i?>i???, as an upward sloping yield curve indicates that investors expect higher future interest rates.

Question 7

According to the expectations theory, if the 1-year rate is 2.5% and the 2-year rate is 3.64%, the expected 1-year rate would be&#10;A) 3.80%.&#10;B) 4.80%.&#10;C) 5.80%.&#10;D) 6.80%.

Accepted Answer

The expectations theory suggests that the future short-term interest rates can be inferred from the current long-term rates. Using the formula for the expectations theory: (1 + 2-year rate)^2 = (1 + 1-year rate) * (1 + expected 1-year rate). Solving for the expected 1-year rate gives approximately 4.80%.

Deck 3: The Structure of Interest Rates