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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 decit if necessary, i.e. to purchase newly issued government bonds in the amount equal to the size of the budget decit for the respective period of time. Suppose that there is no budget decit by the year 2005.

a. find out 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 decit 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 decit is unexpected, will the central bank be able to defend the xed exchange rate?
d. Suppose the government runs a decit 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 decits are anticipated? How does your answer to (e) change? describe briefly.

Microeconomics, Economics

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