Romer short run fluctuation.

Inflation ADo TO IAo - - - Yo Output Figure IV-15. Saving versus Using Your Ammunition: The Initial Situation4. Suppose the economy is in the situation shown in Figure IV -15. Output is below normal and the nominal interest rate is positive. In addition, as the gure shows, the kink in the AD curve occurs at Y Y. This problem asks you to consider the effects of two possible strategies for the central bank. a. Saving your ammunition: Suppose the central bank does not want to cut the nominal interest quickly to zero, since at that point it would lose the ability to cut the nominal rate further. It therefore continues to follow its usual interest rate rule (subject to the zero lower bound). What will be the behavior of output and ination over time? b. Using your ammunition: Suppose that the central bank immediately changes its interest rate rule so that its desired real interest rate at a given combination of output and ination is lower than before. Suppose the change is large enough that it immediately reduces the nominal interest rate to zero. What will be the behavior of output and ination over time? c. Which policy would you recommend