Answer to Question 3:

A rise in observed long-term interest rates relative to observed short-term rates

1. makes it advantageous to borrow long-term and lend short-term because greater inflation is expected in the long-run.

2. makes it advantageous to borrow short-term and lend long-term to take advantage of the difference in rates.

3. might well be explained by an expectation of greater inflation rates in the long-run than in the short-run.

4. means that borrowers and lenders value long-term and short-term bonds equally once an adjustment has been made for expected inflation.

The correct answer is 3. The inflation premium added to the real interest rate equals the expected rate of inflation over the term of the loan. If inflation is not expected to occur during the next year, there will be little inflation premium on one-year bonds. If at the same time a lot of inflation is expected a few years down the road, there will be a large inflation premium on ten-year bonds. We would thus expect interest rates on long-term bonds to be higher than interest rates on short-term bonds, other things being the same.

Option 4 is incorrect because there is no reason why asset holders might not be willing to pay a real interest rate premium on short-term bonds as compared to long-term or vice versa---they therefore needn't regard bonds of different term to maturity as perfect substitutes at zero (or constant) inflation rates. Option 2 is wrong because the difference in short-term vs. long-term interest rates might well reflect an expectation that inflation rates are going to be greater in the long run than in the short run. If you share that view, you might not want to borrow short and lend long. Option 1 is complete nonsense---whether or not you should borrow short and lend long depends on your expectations of the inflation rate relative to the market's expectations. It also depends, as we shall see later, on your attitude toward risk.

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