Fill in the blanks.

The following figure describes how a balance of payments crisis occurs. Suppose the foreign exchange market expects the government to devalue the currency in the future and adopt a new fixed exchange rate E¹>E⁰. This leads to a rightward shift in the curve that measures the expected domestic currency return on foreign currency deposits. Since the exchange rate remains fixed at E⁰, the domestic interest rate must rise to R^*+(E¹-E⁰)/E⁰. The central bank must ______________ foreign reserves and _____________ the money supply in response.

Select one:

a. purchase; increase

b. purchase; decrease

c. sell; increase

d. sell; decrease

Exchange rate, E E0 1 R* +(E-EJE 1 R* +(EO-EYE Domestic interest rate, R 0 R R' +(E-EYE 1 1 1 L(R, Y) 1 1 M2 2 M Real money supply 1 Real domestic money holdings