Suppose that the inflation rate is higher than i*, that the central bank announces it will reduce the inflation rate, and that it actually proceeds to do this. Answer the following:
(a) Suppose that the private sector believes the central bank announcement. What are the effects on the inflation rate and real output? Show this in a diagram.
(b) Suppose that the private sector does not believe the central bank announcement. What are the effects on the inflation rate and real output now? Show this in a diagram.
(c) Explain your results in parts (a) and (b).