COVID-19 and the Zero Lower Bound. This question asks you to analyze the COVID-19 shock in an economy in which interest rates are eventually limited by the zero lower bound. To begin, however, assume the economy starts in its long-run position, with an inflation target of 2%. (a) Show the initial impact of COVID-19 on the economy in the IS-MP diagram and explain briefly what happens and why.

(b) What does the central bank do with monetary policy in response? Draw this policy response in the IS-MP diagram. In answering this question, assume the zero lower bound prevents interest rates from adjusting as much as the central bank would like them to. What is the value of the real interest rate at the zero lower bound?

(c) Now suppose the central bank considers raising its inflation target. Show how this would affect the economy in the IS-MP diagram. What is the economic intuition underlying this affect?

(d) Discuss in a few sentences the implications of your findings for real economies like the U.S. and Europe. Would you recommend raising the inflation target? Why or why not?