Read the following passage carefully and answer the questions that follow.…
2020
Read the following passage carefully and answer the questions that follow.
Under a freely flexible exchange rate system and a stable foreign exchange market, the nation's currency will depreciate until the monetary deficit is entirely eliminated. Under a managed float, the nation's monetary authorities usually do not allow the full depreciation required to eliminate the deficit completely. Under a fixed exchange rate system, the exchange rate can depreciate only within the narrow limits allowed so that most of the balance of payments adjustment must come from elsewhere. A depreciation to the extent that it is allowed stimulates production and income in the deficit nation and induces imports to rise, thus reducing part of the original improvement in the trade balance resulting from the depreciation under a freely flexible exchange rate system. This simply means that the depreciation needed to eliminate a balance-of-payment deficit is larger than if these automatic income changes were not present. Except under a freely flexible exchange rate system, a balance-of-payment deficit tends to reduce the nation's money supply, thus increasing its interest rates. This, in turn, reduces domestic investment and income in the deficit nation, which induces its imports to fall and thereby reduces the deficit. The increase in interest rates also attracts foreign capital, which helps the nation finance the deficit. The reduction in income and in the money supply also causes prices in the deficit nation to fall relative to prices in the surplus nation, thus further improving the balance of trade of the deficit nation.
Ques: According to the passage, deficit in balance of payments leads to
- A.
Price increase in the deficit nation
- B.
Automatic adjustments in income
- C.
Fall in import by surplus nations
- D.
Improvements in the trade balance of the deficit nation
Attempted by 1 students.
Show answer & explanation
Correct answer: D
CONCEPT: In open-economy macroeconomics, when a country's exchange rate is not fully and freely flexible, a balance-of-payments deficit does not correct itself only through currency depreciation. Automatic adjustment channels also operate together: a falling money supply raises domestic interest rates, higher interest rates lower domestic income and relative price levels, and lower income together with lower relative prices reduce imports and make the country's exports more competitive. The combined, self-correcting effect of these linked channels is an improvement in the deficit country's balance of trade.
APPLICATION: The passage traces exactly this chain for a nation running a balance-of-payments deficit:
A balance-of-payments deficit shrinks the nation's money supply.
The shrinking money supply raises domestic interest rates.
Higher interest rates reduce domestic investment and income, which in turn reduces the nation's own imports and also attracts foreign capital to help finance the deficit.
The fall in income and in the money supply also pulls prices in the deficit nation down relative to prices in the surplus nation.
The passage's own concluding line names the result of this whole chain directly: these effects "further improve the balance of trade of the deficit nation."
CROSS-CHECK: contrasting each near-miss option against the passage
Price increase in the deficit nation reverses the passage's stated direction — it says prices in the deficit nation fall relative to the surplus nation, not rise.
Automatic adjustments in income names only the interest-rate-driven fall in income, one link in the middle of the chain — not the chain's stated final outcome for the country's external trade position.
Fall in import by surplus nations misattributes whose imports move: the passage describes the deficit nation's own imports falling, not any change in the surplus nation's imports.
So the outcome the passage explicitly attributes to this whole adjustment sequence is: improvement in the trade balance of the deficit nation.