Macroeconomics, 2nd Edition by Pearson

THE TRADE BALANCE AND EXCHANGE RATES

147

with low inflation so that they can import that country’s price stability. When the

exchange rate is fixed,



E/E

=

0

,

and



t

=



t

*

so that the country’s inflation rate

is aligned to the inflation rate of the country to which it pegs its exchange rate.

Alternatively, proponents of a system of flexible exchange rates argue

that countries can select their preferred national inflation rate

-



t

and that the

exchange rate would compensate passively for the differential in inflation,

given that



E/E

=

-



t

-



t

*.

The empirical backing for the PPP theory is weak, both ...