Exchange Rate Effects on Trade Balance

Steps:

• Current account deficit occurs when imports exceed exports in value.
• Exchange rate appreciation strengthens the domestic currency.
• This makes domestic goods costlier for foreigners, reducing export demand.
• Simultaneously, foreign goods become cheaper domestically, boosting import demand and widening the deficit.

Why A is correct:

• Appreciation increases export prices relative to imports, worsening the trade balance as per the elasticities approach in international trade theory.

Why the others are wrong:

• B: Higher domestic productivity cuts costs, enhancing export competitiveness and narrowing the deficit.
• C: Import quotas limit foreign goods inflow, reducing imports and shrinking the deficit.
• D: Subsidies lower domestic production costs, boosting exports or import substitution, which reduces the deficit.

Final answer: A