Consider an open economy with neither perfect capital mobility nor perfect capital immobility (assume the slope of BP is lower than the slope of LM). Suppose that the country operates under a fixed exchange rate regime (the central bank or monetary authority stands ready to keep the exchange rate fixed). Initially, the economy is in equilibrium at interest rate i₀ and income level Y₀.

Suppose now that the government implements contractionary fiscal policy by reducing government spending. Using the IS-LM-BP model, answer the following with the help of appropriate diagrams:

a. Under the fixed exchange rate regime, what is the impact of the decrease in government spending on (i) domestic interest rate, (ii) domestic income and output, (iii) Balance of Payments and exchange rate, (iv) Central Bank's official foreign exchange reserves. Show on the IS-LM-BP diagram, and explain your results.

b. Now consider the case with relatively immobile international capital, i.e. the slope of the BP curve is larger than the slope of the LM curve (BP is steeper than LM). With contractionary fiscal policy, how would your results change under a fixed exchange rate system (explain and show on the diagram what happens to (i) domestic interest rate, (ii) domestic income and output, (iii) Balance of Payments and exchange rate, (iv) Central Bank's official foreign exchange reserves)? Show carefully using the IS-LM-BP model. Why do you think these two cases (in part a and in part b) have two different outcomes? Explain carefully.