with the aid of the IS-LM diagram, show the effects of a foreign monetary contraction on foreign output and foreign interest rate

In an open economy with fixed exchange rates, the effects of a foreign monetary contraction can be illustrated using the IS-LM model. A monetary contraction is a decrease in the money supply, which can be achieved by central bank actions such as increasing the reserve requirements for banks or selling government bonds.

Here are the steps to show these effects:

1. Draw the initial IS-LM diagram: Draw the IS curve and the LM curve on a graph where the vertical axis represents the interest rate and the horizontal axis represents the output. The point where the IS curve intersects the LM curve is the initial equilibrium point (E0), which corresponds to the initial interest rate (i0) and the initial output (Y0).

2. Monetary contraction: A foreign monetary contraction shifts the LM curve to the left from LM1 to LM2. This is because a decrease in the money supply increases the interest rate at each level of output.

3. Initial response: Without central bank intervention, the economy would move to a new equilibrium point (E1) where the IS curve intersects the new LM curve (LM2). This corresponds to a higher interest rate (i1) and a lower output (Y1).

4. Central bank intervention: To maintain the fixed exchange rate, the central bank increases the money supply, which shifts the LM curve back to the right from LM2 to LM1. The economy moves back to the original equilibrium point (E0) where the IS curve intersects the LM curve. This corresponds to the original interest rate (i0) and the original output (Y0).

5. Effects on foreign output and interest rate: The foreign monetary contraction and the subsequent central bank intervention lead to no change in foreign output and the foreign interest rate. The output and the interest rate initially change due to the monetary contraction, but they return to their original levels because the central bank adjusts the money supply to offset the effects of the monetary contraction.

In conclusion, a foreign monetary contraction in an open economy with fixed exchange rates leads to no change in foreign output and the foreign interest rate, assuming that the central bank successfully intervenes to maintain the fixed exchange rate.