Reading Passage Question
A recent study evaluated the prevailing explanation offered by economists for the Asian financial crisis that began in Thailand during the late 1990s: that a large increase in foreign investment made the region vulnerable to volatility in currency markets. The study conducted technical analysis of various developing markets and showed that a surge in foreign direct investment did not predict large swings in foreign exchange markets of the underlying currencies. Rather, authors of the study suggested an alternative explanation – that the collapse was due to structural weaknesses in the financial systems of certain Southeast Asian markets. One factor contributing to financial instability was the belief that governments would provide support in the event of systemic failure, commonly known since the 2008 recession as “too big to fail”. This phenomenon created reduced incentives to regulate large financial institutions. The resulting structural weakness was not only masked by the rapid growth of the 1980s and early 1990s, it was exacerbated by the precipitous increase of foreign investment as well as Thailand's insistence on keeping the Baht pegged to the dollar. Given this alternative explanation, which implies policymakers could have prevented the crisis, governments in developing nations should prioritize establishing a strong regulatory structure rather than providing rescue packages. Additionally, governments and regulators should allow currency rates to be determined by market forces rather than arbitrarily peg their values to a reserve currency or basket of currencies. Policymakers could also consider controls on capital outflows after market selloffs, encouraging diversification of economies in manufacturing and technology, and creating a plan for structured liquidation of failed large firms.
”A recent study evaluated the prevailing explanation offered”- is a GMAT reading comprehension passage with answers. Candidates must have a solid grasp on English GMAT reading comprehension. There are three comprehension questions in this GMAT Reading Comprehension section. GMAT Reading Comprehension questions are designed to evaluate candidates' abilities to comprehend, analyze, and apply information or concepts. Candidates can actively prepare by answering GMAT Reading Comprehension Practice Questions.
Solutions and Explanation
- The passage suggests which of the following about the role of foreign investment in the Asian financial crisis of the 1990s?
- Regulation of foreign investment through capital controls would likely have exacerbated the crisis.
- Direct investment was a determining factor that led to large swings in foreign exchange markets.
- Its role in financial crises may be mitigated through public policy.
- It resulted in the growth of institutions shielded from systemic failure by implicit government support.
- Countries that allow currencies to be determined by market forces create more favorable environments for foreign investment.
Answer: C
Explanation: The passage supports the third option, which is the correct answer. It refers to the passage's two public policy recommendations. One is that governments in developing countries should prioritize establishing a strong regulatory structure over providing aid. The other is that governments and regulators must allow market forces to set currency rates instead of arbitrarily pegging them to a reserve currency. The remaining options are appealing, but they are invalid because they are inaccurate or contradictory.
- The first sentence of the passage suggests that the highlighted “economists” would be most likely to predict which of the following?
- Markets would continue to be prone to rapid change under circumstances of greater legal oversight despite a possibly greater range of investment.
- Volatility would be mitigated under circumstances of greater regulatory oversight.
- Financial crises could be contained if financial institutions posed less risk of leading to systemic failure.
- Removing the Baht peg to the dollar would reduce incentives for foreign investors to invest in Thailand.
- Markets would be stabilized by foreign investment applied through diversification of portfolios by increasing exposure to other markets.
Answer: A
Explanation: The passage supports the first option, so it is the correct answer. According to the passage, economists believed that a significant increase in foreign investment made the region vulnerable to currency market volatility. Because they preferred this explanation, these economists are likely to believe that increased regulatory oversight would have no effect on volatility. The remaining options are tempting, but they are invalid due to inaccuracies or contradictions.
- The passage mentions each of the following as an appropriate kind of governmental action EXCEPT
- encouraging controlled removal of certain types of institutions
- creating a plan to develop different branches of economy to control impact of the financial service sector
- removing artificial controls on currency fluctuations
- setting limits on the percentage of financial resources that can leave a country during times of economic expansion
- making sure that governments develop strong regulatory structure, even for vital corporations
Answer: D
Explanation: The fourth option is the correct answer. This is due to the fact that it correctly states that governments should consider additional regulation of large institutions in order to stabilize the economy. It is a reversal, however, because the study described in the passage speculates on how to respond during financial crises, not economic expansion. The remaining options are incorrect answers because they are all supported by the passage.
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