Suppose that, as of the end of 2005, a country's money supply is $1,200 million and the central bank's holdings of domestic assets (a.k.a. domestic credit) are equal to $800 million. The country maintains a xed exchange rate, and prices are sticky. Each period, the central bank is prepared to monetize any government budget de cit if necessary, i.e. to purchase newly issued government bonds in the amount equal to the size of the budget de cit for the respective period of time. Suppose that there is no budget de cit by the year 2005.
a. Calculate the value of total internaional asset holdings (a.k.a. international reserves) of the central bank as of the end of 2005. Illustrate this situation on a central bank balance sheet diagram.
b. Now, suppose the government unexpectedly runs a $100 million de cit in the year 2006 and the money supply is unchanged. Illustrate this change on your diagram. What is the new level of reserves?
c. If the de cit is unexpected, will the central bank be able to defend the xed exchange rate?
d. Suppose the government runs a de cit of $100 million each year from this point forward. What will eventually happen to the central bank's reserves?
e. In what year will the central bank be forced to abandon its exchange rate peg and why?
f. What if the future de cits are anticipated? How does your answer to (e) change? Explain briefly.