LO 4, 5 Suppose, in the NKRE model, that from time 0 until time T-1, the natural rate of interest is r1 * , where r1 * 6 - i*, and from time T on the natural rate of interest is r2* 7 0. Also, suppose that the central bank can achieve its inlation target from period T onward, and that the central bank sets the nominal interest rate to zero from time 0 until time T-1.

(a) What will happen to inlation and output from period 0 until period T-1. Explain with the aid of a diagram.

(b) What can the central bank do about the problem that arises in part (a)? Discuss.