1. Suppose a foreign economy engages in a fiscal contraction. Use the Three-Figures Diagram; money market, the IS-LM curves, and the interest parity condition curve to show the effects of this policy on domestic output, interest rate and exchange rate in the following two cases

Consider an economy with fixed exchanged rates. Suppose the price-setting equation is given by P = (1 + m) A The wage-setting equation is given by W = PA*F(u, z) where m is the markup, z are unemployment benefits, u is the unemployment rate, and A is productivity. Assume that A and A are constant. 1. Suppose a foreign economy engages in a fiscal contraction. Use the Three-Figures Diagram; money market, the /S-LM curves, and the interest parity condition curve to show the effects of this policy on domestic output, interest rate and exchange rate in the following two cases: a. Assume that the change in foreign interest rate is larger than the change in domestic interest rate caused by the initial shift of domestic /S curve. [6 marks] b. Assume that the change in foreign interest rate is equal to the change in domestic interest rate caused by the initial shift of domestic /5 curve. [6 marks] c. Compare your results and explain? [4 marks]