According to the Absorption approach, a currency depreciation leads to an improvement in the balance of trade when a country
A) operates at full employment with no excess production capacity.
B) operates at unemployment with excess production capacity.
C) realizes high rates of inflation.
D) realizes high rates of deflation.

Question

Quizplus · Accepted Answer

The Absorption approach suggests that a currency depreciation leads to an improvement in the balance of trade when a country operates at unemployment with excess production capacity. This is because the depreciation makes the country's exports cheaper and more competitive in the global market, leading to an increase in export demand and production. At the same time, domestic consumption decreases due to the higher prices of imported goods, leading to a decrease in import demand. This helps to rebalance the trade deficit. However, if the country is already operating at full employment with no excess production capacity, then the increase in export demand may not be met due to production constraints, leading to inflationary pressures instead of a improvement in the balance of trade.

According to the Absorption Approach, a Currency Depreciation Leads to an Improvement