4. Defending the Peg The country of Riqueza has 2000 million escudos in its money supply, of which 1200 million are backed by domestic government bonds. Assume that Riqueza maintain fixed exchange rate of 1 escudo per dollar, the foreign interest rate remains unchanged, and money demand takes the usual form, Md=L(i)Y. a. Show the balance sheet of Riqueza's central bank. Depict it using the balance sheet sheet diagram (the one with domestic credit B on the vertical axis and the money supply M on the horizontal axis). What is the backing ratio? b. Suppose that the central sells 400 escudos of government bonds. Show how this affects the central bank's balance sheet and depict it on the balance sheet diagram. - What happens to Riqueza's money supply? To the backing ratio? c. Now, starting from this new position, suppose that there is an economic downturn in Riqueza, so that real income contracts by 10 percent. How does this affect money demand in Riqueza? Explain how this will affect the money market and the foreign exchange market. (That means you need to depict what is happening using the money demand/supply and FR/DR pictures.) d. Using a new balance sheet, show how the change in part c affects Riqueza's central bank. Depict the change using the balance sheet diagram. What happens to domestic credit? To international reserves? (Note: You should calculate numerical values.) Explain how this will affect the money market and the foreign exchange market. (Again, you need to depict this using the money demand/supply and FR/BR pictures.) e. How will the change above affect the central bank's ability to defend the fixed exchange rate. What is the backing ratio now? Describe how this situation differs from the one in which the government buys government bonds, as in part b