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Question - Initially the central bank balance sheet at Home is the following. Money supply is 500 pesos (M=500), the stock of local bonds is 100 (B=100), and the foreign reserves are 400 dollars (R=400). As in classes, the exchange rate is fixed and equal to one (E=1).
a) Show this balance sheet using a graphical representation as in classes. Home is hit by a crisis that results in a drop in output. As a result, the money demand declines by 20%.
b) Describe the type of operation the central bank has to do in order to keep the exchange rate fixed.
c) Show the new central bank balance sheet using a figure like the one used in a.
d) Show that the central bank is not able to defend the exchange rate if the decline in money demand is 90%.
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