Abraham wrote at 2016-05-04 05:57:02
Easy. The gap is financed by the central bank selling FX to cover the gap. According to the monetary approach to the balance of payments, the sell of FX will reduce the domestic money supply and thus it will show up in lower spending on both domestic and imported goods, thus reducing the trade deficit. This situation is unsustainable in the long run since the central bank may bot have enough FX to cover the gap indefinitely, unless there is a fall in the domestic price level. The domestic currency must depreciate to reduce the trade balance by stimulating exports and reducing imports. The fall in the price level implies exports are cheaper for foreigners and imports more expensive for domestic consumers. Under a flexible exchange rate system, if the central bank does not intervene by selling FX the domestic currency will depreciate to close the gap.