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: What is needed to completely eliminate the monetary deficit?
- A.
Conditioned exchange rate
- B.
Complete currency depreciation
- C.
Volatile foreign exchange market
- D.
Free exchange rate system
Show answer & explanation
Correct answer: B
CONCEPT: In a literal-comprehension question, the answer must come from the exact relationship stated in the passage. When a passage says an action continues until a condition is met, that action identifies what removes the stated problem.
Here the governing idea is exchange-rate adjustment: depreciation can remove a monetary deficit only when the required depreciation is allowed to occur fully; if it is restricted, other balance-of-payments adjustments have to carry the correction.
APPLICATION: The passage says that under a freely flexible exchange-rate system, the nation's currency will depreciate until the monetary deficit is entirely eliminated. It also says that a managed float usually does not allow the full depreciation required to eliminate the deficit completely. Therefore, the needed action is complete currency depreciation.
Conditioned exchange rate describes a restricted rate setting, not the eliminating mechanism stated in the passage.
Volatile foreign exchange market conflicts with the passage's stable foreign-exchange-market condition.
Free exchange rate system names the regime in which the adjustment can happen, but the question asks for the needed exchange-rate movement itself.
CROSS-CHECK: The wording “until the monetary deficit is entirely eliminated” ties elimination to the currency's depreciation, and the later phrase “full depreciation required to eliminate the deficit completely” confirms the same reading.
Result: Complete currency depreciation is the value supported by the passage.