Using a first-generation model, we’ve seen that fiscal policy plays a role in the central bank’s ability to maintain the exchange rate peg. Using a central bank balance sheet diagram, illustrate how this situation affects reserves, domestic credit, and the money supply. The money supply is initially 900 million sols and the central bank holds 600 million sols in domestic credit and P= P* = E=1 and i* = 7%.

a. Calculate the backing ratio for this country and illustrate the central bank balance sheet diagram. Label this point 1 on your diagram million sols. Backing ratio =R/M= 37.5%.

b. Beginning at time, the government runs a deficit of 75 million sols each year. You may assume that the deficit growth is not anticipated. On your central bank diagram, label the economy’s outcomes (points 2, 3, etc.).

c. When will the central bank be forced to float the currency? Before this point, what is the inflation rate? The expected depreciation in the currency?

d. Suppose that after one year of observing the 75 million deficit, investors adjust their expectations. How does your previous answer change? Note that investors do not adjust their expectations until after one year of observing deficits.