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.
Question: Limited depreciation of currency is allowed to
- A.
Nullify trade balance under free exchange rate system
- B.
Restrict foreign investment
- C.
Increase domestic production
- D.
Curtail higher income
Attempted by 1 students.
Show answer & explanation
Correct answer: C
CONCEPT: In a reading-comprehension item, the answer must follow the exact causal statement in the passage, not outside economics knowledge. Currency depreciation can improve the external balance, but the passage separates full depreciation under a flexible rate from limited depreciation under managed or fixed arrangements.
APPLICATION: Here the passage says that depreciation, to the extent allowed, “stimulates production and income in the deficit nation.” The option value “Increase domestic production” directly restates the production part of that sentence.
CONTRAST: The near-miss choices do not match the stated effect:
Nullifying the trade balance under a free exchange rate system confuses full adjustment in a freely flexible system with limited depreciation; the passage says limited depreciation does not eliminate the deficit completely.
Restricting foreign investment reverses the later capital-flow point; the passage says higher interest rates attract foreign capital, not that depreciation restricts it.
Curtailing higher income reverses the income effect; the passage says allowed depreciation stimulates income and then imports.
CROSS-CHECK: Replacing the stem with the passage phrase gives “limited depreciation is allowed to stimulate production and income.” Among the offered values, the production effect is expressed as “Increase domestic production.”
Result: Increase domestic production.