Suppose that a country's money supply is $1,200 million and its domestic credit is equal to $800 million in the year 2005. The country maintains a fixed exchange rate, the central bank monetizes any government budget deficit, and prices are sticky.
a. Compute total reserves for the year 2005. Illustrate this situation on a central bank balance sheet diagram.
b. Now, suppose the government unexpectedly runs a $100 million deficit 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 deficit is unexpected, will the central bank be able to defend the fixed exchange rate?
d. 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?
e. In what year will the central bank be forced to abandon its exchange rate peg and why? f. What if the future deficits are anticipated? How does your answer to part (e) change? Explain briefly.