Consider the previous question. In this case, we assume investors are forward-looking and hear news that the government deficit will grow at 20% each year.

a. How will investors respond to the announcement of the budget deficit? What happens to reserves as a result?

b. Calculate the level of critical reserves at which the speculative attack occurs. Is this central bank holding sufficient reserves to prevent a speculative attack? According to your calculation, when should the speculative attack occur?

c. Illustrate the behavior of the following variables between and domestic credit, reserves, and the money supply.

d. Illustrate the behavior of the following variables between and the nominal interest rate, the price level, and the exchange rate.

e. Why does the price level “jump” when the country switches from fixed to floating in the myopic case? Why is this not possible in the forward-looking case?The textbook examines what happens when governments run persistent budget deficits in a first-generation model. Suppose that a country begins running large budget surpluses. In this case, will the country be forced to float? In the forward-looking model, is a speculative attack possible in this case? Explain