In the basic New Keynesian model, suppose that there is an increase in the future marginal product of capital.

a. Suppose that the central bank does nothing. What will be the effect on current inflation and on output?

b. Suppose the economy initially has inflation equal to the central bank’s inflation target and an output gap of zero. When the shock occurs, what should the central bank do?

c. Explain your results in parts (a) and (b) with the aid of diagrams.