How do trade deficits correct themselves?

A floating exchange rate system allows the value of a nation's currency to be determined by the market forces of supply and demand relative to other currencies. When a country experiences a trade deficit, meaning it imports more goods and services than it exports, the increased demand for foreign currencies can lead to depreciation of the domestic currency. A weaker currency makes exports cheaper and imports more expensive, which can help to reduce the trade deficit over time.

As the country's exports become more competitive on the global market due to lower pricing in foreign currencies, demand for those exports may increase. At the same time, higher import prices could lead consumers and businesses domestically to substitute away from imported goods in favor of locally produced products. These adjustments in trade balances naturally occur in response to changes in currency value when a floating exchange rate is at play, effectively helping to correct a trade deficit.

In contrast, the other choices do not adequately address the mechanisms by which trade deficits self-correct. For instance, an increase in the dollar's value or arbitration with the World Trade Organization does not inherently lead to the automatic adjustment of the trade balance. Similarly, while wars may lead to debt cancellation, they do not provide a sustainable or predictable solution to trade deficits.