Suppose the yield curve is initially horizontal.Suppose the current one-year interest rate increases by 4% while the expected future one-year interest rate does not change.Which of the following will tend to occur?
A)i₂t will increase by 4%
B)i₂t will increase by 2%
C)i₂t will increase by less than 2%
D)i₂t will decrease by 2%

Question

Quizplus · Accepted Answer

When the current one-year interest rate increases by 4% and the expected future one-year interest rate remains unchanged, the two-year interest rate (i₂t) will tend to increase by less than the full 4% increase in the one-year rate due to the averaging effect over two years, resulting in an increase of about 2%.

Suppose the Yield Curve Is Initially Horizontal