Question 1:

The Danish krone is currently pegged to the euro. Using the IS-LM-FX model for Home (Denmark) and Foreign (Eurozone), illustrate how each of the following scenarios affect Denmark:

A. The Eurozone reduces its money supply.

1. Denmark cuts government spending to reduce its budget deficit.
2. The Eurozone countries increase their taxes.

Question 2:

Consider the central bank balance sheet for the country of Riqueza. Riqueza currently has 2,000 million escudos in its money supply, 1,200 million escudos of which is backed by domestic government bonds; the rest is backed by foreign exchange reserves. Assume that Riqueza maintains a fixed exchange rate of one escudo per dollar, the foreign interest rate remains unchanged, and money demand takes the usual form,M/P=L(i)Y. Assume prices are sticky.

1. Show Riqueza's central bank balance sheet, assuming there are no private banks. What is thebacking ratio?
2. Suppose that Riqueza'scentral bank buys 400 million escudos in government bonds. Show howthis affects the central bank balance sheet. Does this change affect Riqueza's money supply?Explain why or why not. What is the backing ratio now?
3. Now, starting from this new position, suppose that there is an economic downturn in Riqueza, so that real income contracts by 10%. How will this affect money demand in Riqueza? How will forex traders respond to this change? Explain the responses in the money market and the forex market.
4. Using a new balance sheet, show how the change described in part (c) affects Riqueza's centralbank.What happens to domestic credit? What happens to Riqueza's foreign exchange reserves?Explain the responses in the money market and the forex market.