Q2. (30 marks) Under the gold standard, 2.1 We discuss "rules of the game": The selling of domestic assets to acquire money when gold exited the country as payments for imports. This decreased the money supply and increased interest rates, attracting financial inflows to match a current account deficit. Traditionally, central bank cannot affects the interest rate under fixed exchange rate system. However, in the more realistic imperfect asset subsitutability framework p = p(B - A), the central bank can affect the interest rate level. Use the following diagram to explain how a central bank can alter the domestic interest rate, while holding the exchange rate fixed, under imperfect asset substitutability. Exchange rate, E Sterilized purchase of foreign assets Risk-adjusted domestic-currency retum on foreign- currency deposits. F1 RE - EVE + p(B- A) A + (E - EYE + P(B- A') Domestic interest rate, R L(A, Y) Real money supply Real domestic money holdings 2.2 Suppose we are talking about two large countries, which are macroeconomic interdependent. Now we have p(B - A, B* - A*) . 1) Suppose the country UK government issues extra government bond to finance for the military expenditure, what will happened to the premium of holding USD asset. 2) Suppose the Bank of England follows "rules of the game" to buy domestic asset when gold enters the country, what will happended to the premium of holding USD asset