In some country, the rate of inflation is expected to increase from 2 percent to 5 percent and people fear that the increase will be permanent if the central bank does not take action. Currently the nominal interest rate under control of the central bank is 4 percent and does not yet reflect the expected increase in inflation. Use a diagram for the real interest rate and the inflation rate to explain why it is likely that the central bank will have to increase the interest rate by a large amount. In both diagram and text, indicate clearly whether you deal with the real rate or with the nominal rate.

If such an increase in expected inflation as above is related to higher prices for food in a developing country where food prices are a big part of inflation, would you then change the analysis from part (a) and give a different recommendation to the central bank? Give one argument in favour of not increasing the interest rate by a large amount and one argument against.