) Suppose that the economy is well described by the New-Keynesian model with partial sticky prices. Assume that the Zero Lower Bound (ZLB) on nominal interest rate is binding. In your answer below, keep in mind the consumers and firms optimal decisions that give rise to the model and explain how and why agents decisions change. a) (2 marks) This is a Multiple Choice question. Choose one correct answer only. What are the implications of the ZLB in our New-Keynesian model? A. Negative shocks are amplified by the flat shape of the LM curve, in which real interest rates cannot go below +1 to accommodate demand. B. Negative shocks are amplified by the flat shape of the LM curve, in which real interest rates cannot go below -+1 to accommodate demand. C. Negative shocks are mitigated by the flat shape of the LM curve, in which real interest rates cannot go above +1 to accommodate demand.

D. Negative shocks are amplified by the vertical shape of the LM curve, in which real interest rates cannot go below -+1 to accommodate demand. b) (8 marks) Bank runs generate a large increase in the interest spreads (i.e. the gap between the borrowing rates of firms and deposit rates). What are the effects on aggregate outcomes (Y, P, r)? How does it compare to the case where the ZLB is not binding? Use diagram to support your answer. c) (5 marks) The Central bank, as lender of last resort, decides to inject large amounts of money into financial institutions. Analyse the transmission mechanism of this policy action as well as its effects on output and price level.