In this question, assume that the world is under a fixed exchange rate regime.

(a)

Suppose that a domestic country reduces its spending on education. Describe a

stabilization policy that a central bank could impose to maintain fixed exchange

rate. Use DD-AA model to diagrammatically explain it.

(b)

Suppose the reduction in education spending makes foreign exchange market

to expect the domestic government to devalue its currency in the future and

adopt a new fixed exchange rate. Using the money market equilibrium model

we derived in chapter 4 (see Figure 4-6 in your textbook!), explain how a central

bank must adjust its reserves to maintain fixed exchange rate.