Suppose the yield curve is initially horizontal and the current one- year interest rate increases by 2% while the expected future one- year interest rate does not change. This event will tend to cause:
A) i2t to increase by 1%.
B) i2t to increase by less than 1%.
C) i2t to decrease by 2%.
D) i2t to increase by 2%.
E) i2t to decrease by 1%.

Question

Quizplus · Accepted Answer

When the current one-year interest rate increases by 2% and the expected future one-year interest rate does not change, the two-year interest rate (i2t) will tend to increase by 1%. This is because the two-year rate is an average of the current one-year rate and the expected future one-year rate. With only the current rate increasing, the average rate (i2t) will increase, but by less than the full 2% increase of the current rate, resulting in a 1% increase.

Suppose the Yield Curve Is Initially Horizontal and the Current