Answer: Inflation increasing from 1.0% to 3.0%

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%**

Author: Manit Arora