What is a flaw in the argument that flexible exchanges rates will eliminate trade imbalances?

Question

BlackTom AI · Accepted Answer

Flexible exchange rates change relative prices, but depreciation or appreciation will not necessarily eliminate a trade imbalance because of several distinct, empirically important mechanisms.

1) Relevant knowledge points and concepts
- Exchange-rate pass‑through: the degree to which exchange-rate changes affect domestic import/export prices.
- Demand elasticities and the Marshall–Lerner condition: a devaluation improves the trade balance only if the sum of absolute import and export demand elasticities exceeds 1.
- The distinction between current account (goods/services) and financial account (capital flows).
- Composition of foreign‑exchange turnover: most FX trading is financial (capital) rather than trade related.

2) Step‑by‑step reasoning
- If pass‑through is low, a 10% depreciation might raise domestic import prices by only a few percent; exporters may not gain much price advantage.
- If demand elasticities are low, quantity responses to price changes are small, so import spending may not fall enough (and export revenues may not rise enough) to correct the deficit.
- Large capital inflows (financial account pressures) can offset any adjustment in the current account: investors buying domestic assets require currency, pushing the exchange rate in the opposite direction.
- Because FX turnover is dominated by financial transactions, supply and demand driven by trade are a small share of total FX demand, so trade‑driven forces can be drowned out.

3) Illustrative calculation (intermediate steps)
- Suppose currency depreciates 10%, pass‑through to import prices = 30% → import prices rise 0.10 × 0.30 = 3%.
- If import quantity elasticity = −0.2, quantity falls by 0.2 × 10% = 2%? (correct calculation uses price change: 0.2 × 3% = 0.6%). Using the price change: quantity falls 0.6%.
- Change in import value ≈ +3% (price) + (−0.6%) (quantity) = +2.4% → import bill rises, worsening the balance.

4) Why the correct answer is correct
Each listed statement identifies a genuine mechanism that blocks automatic correction by flexible rates: low pass‑through/elasticities, other determinants of exchange rates, financial‑account causes of imbalances, and the small share of trade in total FX demand. Since all these are valid and complementary flaws, the best choice is the option that includes all of them.

5) Why the other options alone are insufficient
- Any single option points to one real problem, but none alone captures the full set of reasons why flexible rates may fail. The combination of all factors explains why adjustment can be weak, slow, or reversed.

6) Conclusion
All listed points are valid flaws, so the correct answer is "all of these," which matches the provided answer.

What is a flaw in the argument that flexible exchanges rates will eliminate trade imbalances?Single choice

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