The government of country A is running a budget deficit of 500 million pesos per year. To finance it, the government sells treasury bills to the central bank. The exchange rate is fixed at 20 pesos per dollar. Assume that the international price level is fixed and that the central bank has a large amount of foreign reserves.
a. Calculate the yearly change in the foreign reserves of the central bank. Would you expect this process to be smooth over time? Why?
b. Describe the evolution of the price level, the exchange rate, and nominal and real monetary balances before and after the exhaustion of the foreign reserves of the central bank.