In this study, cycle simulation was performed to investigate the effect of EGR on combustion characteristics and emissions including NO and soot using a two-zone model in a DI diesel engine. The NO formation was well predicted for different EGR rate and temperature using a two-zone model. The oxygen in the inlet charge was replaced by CO$_2$ and H$_2$O with EGR. The reduction in the inlet charge oxygen resulted in very large reduction in NO level at the same inlet charge temperature. The effect of EGR was to reduce the burned gas temperature. When EGR was increased from 0% to 15%, the peak flame temperature was decreased by 50$^{C}$ and it caused about 57% NO reduction. EGR caused increase of the overall inlet charge temperature which offset some of benefit of lower flame temperature resulting from O$_2$ displacement. Cooling the EGR was confirmed to provide additional benefits by lowering NO emission. It also reduced soot emission.