University of Pennsylvania

The Wharton School

FNCE 101
Problem Set #5
Fall 2016

Term Structure of Interest Rates and Taylor Rule

Professor J. Siegel

1. Looking at historical empirical evidence, is the term structure of interest rates in the
US generally upward sloping or downward sloping? Give three possible
explanations for the upward bias of the curve.

2. Why does the term structure invert before an economic contraction? Provide
reasons for the movements in both short-term rates and long-term rates.

3. Suppose the current one-year rate is 0.75%, and the one-year forward rate one year
from now is 1.00%. Which of the following must be true if the term structure risk
premium is positive (explain your answer):
a. Interest rates are expected to rise;

b. The current two year interest rate must be less than 0.9%

4. Suppose the current level of the one-year Treasury bill is 1.50%

and the two-year rate is 2.00%.
a. If we assume that the term risk premium is positive:
1

Can we determine whether the shape of the expectations

term structure: upward sloping, downward sloping, flat or
uncertain? Explain your answer.

b. If we assume that the term risk premium is negative:

i. Can we determine whether the shape of the
expectations term structure: upward sloping,
downward sloping, flat or uncertain? Explain your
answer.

ii. Please derive the exact value, or the range of

possible values, for the expected one year rate
one year from now.

5.

Assume there are two possible values for the one-year

interest rate one year from now with the following associated
probabilities of occurrence:
Value
1.55%
1.85%
a.

Probability
60%
40%

Given that the one-year rate is 1.80% and the two-year

rate is 1.95%, does the expectations hypothesis of the
term structure of interest rates hold? Why or why not?

b. Given the information above, what is the forward rate 1i2f

? What is the implied risk premium (L2 in the notes) in
the two-year rate? Show your work.

6. Use the Taylor equation to answer the following questions.

You know the equilibrium short term real interest rate is 3%,
the target inflation rate is 1.0%, and the equilibrium
unemployment rate is 6%. Both adjustment factors are 0.50
and Okuns Law holds (i.e. a 2:1 relationship exists between
the decrease in unemployment rate and the increase in the
GDP).
a. What funds rate should the Fed target if inflation is 1.0% and
the unemployment rate is 6%?

b. What is the Taylor Rule interest rate if inflation is 2.5% and the
unemployment rate is 0.5% above equilibrium?

c. If the Taylor Rule holds at a funds rate of 4% and inflation =

3.00%, what is the Unemployment rate?

d. What interest rate should the Fed set if the inflation rate is
zero and the Unemployment rate is 11%? Can the Fed do
anything else to help the economy? If so, what?