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: Why full depreciation is not allowed?
- A.
BoP adjustment should come from elsewhere
- B.
Because of foreign exchange shortage
- C.
For improving trade balance
- D.
Full depreciation does not eliminate deficit
Show answer & explanation
Correct answer: A
Concept
In a passage-based question, the answer must come from the cause-and-effect link stated in the passage, not from outside assumptions. When an exchange-rate system does not let depreciation move fully, the whole balance-of-payments gap cannot be corrected through depreciation alone.
The remaining adjustment must therefore come through other mechanisms such as income, imports, interest rates, capital flows, or prices, depending on the system described.
Application
The passage first says that under a freely flexible exchange rate, depreciation can continue until the deficit is eliminated.
It then contrasts managed float and fixed exchange-rate systems, where monetary authorities or narrow exchange-rate limits prevent full depreciation.
Because full depreciation is restricted, the passage states that most of the balance-of-payments adjustment must come from elsewhere.
Contrast
Foreign exchange shortage is not given as the reason in the passage; the passage focuses on exchange-rate limits and policy control.
Improving trade balance is an effect of allowed depreciation, not the reason full depreciation is restricted.
The claim that full depreciation does not eliminate the deficit reverses the passage, which says free flexibility can continue depreciation until the deficit is eliminated.
Result
So the reason is: BoP adjustment should come from elsewhere.