Use the Fisher approximation:

$i = r + \pi$

Current one-year nominal rate is 3.0% and the current one-year real rate is 2.0%, so current inflation is:

$\pi(0,1)=3.0\%-2.0\%=1.0\%$

For the two-year nominal zero rate of 4.0% under the expectations theory, the average of the current one-year nominal rate and the expected one-year nominal rate in year 2 must equal 4.0%:

$`$2`\times 4.0% = 3.0% + i_{\text{expected in year 2}}$$

So the expected one-year nominal rate in year 2 is 5.0%. If the real rate is expected to remain constant at 2.0%, then expected inflation in one year is:

$`$5.0`% - 2.0% = 3.0%$$

So inflation is expected to increase from 1.0% to 3.0%.

Correct answer: C. Inflation increasing from 1.0% to 3.0%