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 happens under a free exchange system?
- A.
Reduction in money supply
- B.
Larger depreciation than in the absence of automatic income changes
- C.
Increase in interest rates
- D.
Less domestic investment
Show answer & explanation
Correct answer: B
Concept: A detail-based reading-comprehension question often turns on an “except” clause: when a passage states that a pattern holds for every case except one named condition, the effect described in that clause belongs to the OTHER conditions, not to the named exception — the exception instead keeps whatever alternative effect the passage assigns to it earlier in the text.
Application: Tracing the passage step by step:
The passage opens with the freely flexible (free) exchange-rate case: the currency depreciates until the monetary deficit is fully eliminated, with no mention of any money-supply contraction here.
It contrasts this with a managed float (partial depreciation only) and a fixed system (depreciation confined to narrow limits, so most adjustment must occur through other channels).
It then notes that the depreciation itself stimulates income and imports, offsetting part of the trade-balance gain achieved under the freely flexible system — so the depreciation needed to close the deficit turns out larger than it would be if these automatic income changes were absent. This sentence describes the free exchange-rate mechanism directly.
The very next sentence begins “Except under a freely flexible exchange rate system,” and assigns the chain — deficit reduces money supply, which raises interest rates, which cuts domestic investment and income, which cuts imports and attracts foreign capital — explicitly to the regimes OTHER than the freely flexible one.
So three of the four listed effects (money-supply reduction, higher interest rates, lower investment) are the passage's account of what happens under those other regimes, carved out of the free exchange-rate case by that “except” clause; only the statement about needing a larger depreciation because of automatic income changes is tied by the passage to the free exchange-rate system itself.
Cross-check: Reading the “except” clause on its own confirms this scoping: it explicitly excludes the freely flexible system from the money-supply / interest-rate / investment chain, leaving the depreciation-magnitude statement as the only passage-sourced effect that applies under a free exchange system.
Why the other options don't fit:
Reduction in money supply — the passage's “except” clause assigns this to the managed-float and fixed regimes, not to free exchange.
Increase in interest rates — the second link in that same excepted chain, so it too belongs to the non-free regimes.
Less domestic investment — the third link in the chain, again carved out of the free exchange-rate case by the same clause.
Result: So the only effect the passage actually assigns to a free exchange-rate system is that a larger depreciation is needed than would be required in the absence of these automatic income changes — matching “Larger depreciation than in the absence of automatic income changes.”