Consider the central bank balance sheet for the country of Patria. Patria currently has 2,500 million lira in its money supply, 1,800 million of which is backed by domestic government bonds. Assume that Patria maintains a fixed exchange rate and that the foreign interest rate remains unchanged.

a. Show Patria’s central bank balance sheet, assuming there are no private banks. Calculate the backing ratio.

b. Suppose that Patria’s central bank sells 300 million lira in government bonds. Show how this affects the central bank balance sheet.

c. Calculate the new backing ratio. Does this change affect Patria’s money supply? Explain why or why not.

d. Now suppose that there is an economic recession in Patria so that output falls by 5%. How will this affect money demand in Patria? How will forex traders respond to this change? Explain.

e. Using a new balance sheet, show how the change described in (d) affects Patria’s central bank (starting from the new balance sheet in [b]), assuming that real money balances change by 200 million lira. What happens to domestic credit? What happens to Patria’s foreign exchange reserves? Calculate the new backing ratio.