LO 3 Suppose that the natural rate of interest decreases and that central bank is constrained by the zero lower bound, with inlation below the central bank’s target and a positive output gap. Further, suppose that if government spending goes up permanently, anticipated future inlation will increase because of a Phillips curve efect in the future.

(a) What will happen if the central bank commits to a future higher inlation target, assuming that the nominal interest rate stays at zero?

(b) What will happen if the central bank commits to the right amount of inlation in the future?

(c) Explain your results with the aid of diagrams.