Suppose that a country's money supply is $1,200 million and its domestic credit (i.e., the supply of
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Question:
Suppose that a country's money supply is $1,200 million and its domestic credit (i.e., the supply of government bonds) is equal to $800 million in the year 2020. The country maintains a fixed exchange rate, the central bank monetizes any government budget deficit, and prices are sticky.
- Compute total reserves for the year 2020. Illustrate this situation on a central bank balance sheet diagram.
- Now, suppose the government unexpectedly runs a $100 million deficit in the year 2021 and the money supply is unchanged. Illustrate this change on your diagram. What is the new level of reserves?
- If the deficit is unexpected, will the central bank be able to defend the fixed ex- change rate?
- Suppose the government runs a deficit of $100 million each year from this point forward. What will eventually happen to the central bank's reserves?
- In what year will the central bank be forced to abandon its exchange rate peg and why? [Assume for this question that government deficit comes as a surprise every year, that is, no one anticipates it.]
- What if the future deficits are anticipated? How does your answer to part (5) change? Explain brieflyin words.
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