The real risk-free rate of interest is 4 percent. Inflation is expected to be 2 percent this coming year, jump to 3 percent next year, and increase to 4 percent the year after (Year 3). According to the expectations theory, what should be the interest rate on 2-year, risk-free securities today?

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A:

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Interest Rate

When you deposit your money with the bank, the deposit earns you some extra money at the end of the specific period – something more than what you deposited. That amount of money that the bank pays you for keeping the money with the bank is the “interest” and the percentage at which the bank pays you for your amount is called the “interest rate”.