In late 1980, the U.S. Commerce Department released new data showing inflation was 15%. At the time, the prime rate of interest was 21%, a record high. However, many investors expected the new Reagan administration to be more effective in controlling inflation than the Carter administration had been. Moreover, many observers believed that the extremely high interest rates and generally tight credit, which resulted from the Federal Reserve System’s attempts to curb the inflation rate, would lead to a recession, which, in turn, would lead to a decline in inflation and interest rates. Assume that at the beginning of 1981, the expected inflation rate for 1981 was 12%; for 1982, 9%; for 1983, 8%; and for 1984 and thereafter, 6%.
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