Question

In a floating exchange rate system, a current account deficit is likely to be corrected by

a) a depreciation in its exchange rate

b) an appreciation of the home currency

c) a prolonged period of hyperinflation

d) an expansion of domestic money

e) a decrease in domestic tax rates

Answer 1

Current account deficit occurs when the import of goods and services is greater than the exports. TO make the exports more attractive, the domestic currency is depreciated so that for every unit of foreign currency more of domestic currency is available, therefore, the price of domestic goods in the foreign market becomes more attractive and this boosts exports.

So option b is incorrect because we have to depreciate the home currency. Prolonged hyperinflation will not be good even if it depreciates home currency because it will bring economic instability so option c is incorrect. An expansion of domestic money supply will lead to lower interest rates and inflation which will not impact the foreign trade and reducing tax rates because it will create greater disposable income and people will import more. So option d and e are incorrect

Depreciating exchange rate wil happen when home currency is depreciated, so option a is correct